Benjamin Graham on Inflation

Columbia had written the standard text on property valuation and often asked that Ben serve as a companion witness in complicated cases where Ben's practical experience confirmed the professor's theory. The standard compensation was $100 per day for preparation ($460 in 1977 dollars) and $250 for each day in court. Ben regarded these rates as generous. Many of the cases involved the valuation of railroad property for property taxes or reorganizations and were most complex, requiring days of preparation. Since the dollar amounts at stake were large, Ben was often subjected to several days of extensive cross-examination by the opposition as they tried to expose any errors or uncertainties in his presentation. Ben's thorough preparation gave him the sound basis for confident rebuttal of these courtroom attempts. BEN BECOMES AN ECONOMIC THEORETICIAN Everyone in the investment community is forced to pay attention to broad economic developments. During the depression of 1921-1922, Ben thought a great deal about the origins of business cycles and possible ways of ameliorating them. He came to the conclusion that the chief cause was the lack of sufficient purchasing power to absorb the increased production that had resulted from the previous boom. Then Ben came across J. A. Hobson's classic The Economics of Unemployment, which had set forth this thesis some years earlier. (Hobson's book was an important precursor of John Maynard Keynes.)

Prices, after a sharp rise during World War I and in that postwar boom, fell precipitously in 1921-1922. Many plans were advanced for stabilizing the general level of prices. The best known was Irving Fisher's proposal for a compensated dollar. The gold content of the dollar would be changed under this plan to compensate for changes in purchasing power. Ben decided that a preferable approach would be to give monetary status to a designated "market basket" of some 21 worldwide basic raw materials. Producers of these commodities could sell them as a package to the Treasury Department in much the same manner as gold, then exchangeable for the dollar at a fixed rate or gold point. Ben did nothing to promote his plan. Some months later, Thomas A. Edison devised a somewhat similar plan based upon farm commodities that would be sold to the Treasury at a fixed price. The economic recovery of the mid-1920's then got under way, with a great expansion in business volume, and accompanied by unusual stability in prices. Ben was busy with his investment activities.

If this plan for linking commodities and currencies had been adopted, it might have helped to avoid the extremes of price inflation in the mid-1970's. BROADWAY Ben's love of reading the world's classics--often in their original language-led him to write a play. In the same year (1934) that the first edition of Security Analysis was published, his play "Baby Pompadour" appeared on Broadway. The critic for the New York Times had the following comments to make: If one of Mr. Graham's students at Columbia University were to turn in an essay on security analysis as trite and diffused in its substance as this little play of his about a nationally famous journalist whose editorial policies are influenced by a moronic chorus-girl mistress, then the student would undoubtedly receive a D minus--and for very good reason, too. As a well-known figure in the financial world, Mr.nor

sold by direct mail to the consumer at a reduced rate, as no commissions had to be paid to insurance agents. The policies were available only to government employees, a group that fortunately averaged fewer claims than most. The company had exceptional growth during its first dozen years and this continued after the Graham-Newman purchase. In 1958, it was decided to offer insurance to professional, managerial, technical and administrative workers, as well as government employees. This broadened the market from 15 percent of car owners to 50 percent. Again, these new policyholders also turned out to be preferred risks. In the following years, growth and profitability continued at an exceptional pace until GEICO became the nation's fifth largest automobile insurer. However, the days of 15 percent underwriting profit margins were over; GEICO was now so large that insurance commissioners would grant rates aimed at producing only a five percent underwriting margin, the same rates granted to other large insurance companies. Starting in 1974 costs rose as inflation accelerated. Adding in the problems of no-fault insurance and low rates, losses skyrocketed and GEICO's net worth dropped from $144 million at the start of 1975 to $37 million at the end of the year. A great many changes have been made and it is expected that 1977 will see GEICO return to profitability.

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.

Graham's second chapter takes up the question that every fixed-income investor must answer: how does inflation change the calculation of an adequate return. The investor who buys a bond yielding three percent when inflation is running at two percent has earned, in real terms, about one percent. If inflation accelerates to five percent, the same bond produces a real loss of about two percent per year, compounded. Graham's reading of history is that inflation is the bondholder's structural enemy, and that the postwar investor could not assume that bond coupons alone would preserve purchasing power over a working lifetime. The investor's response to inflation, in Graham's framework, is not to abandon bonds but to recognize that bonds alone cannot carry the full weight of the long-horizon portfolio. Equities, with their claim on real earnings and pricing flexibility, are the inflation hedge that complements the bond's nominal certainty. Graham is careful not to oversell equities as an inflation hedge. He notes that the empirical case for common stocks as inflation-protected assets is weaker than the conventional wisdom of the postwar years. Stocks do well when businesses do well; businesses do not necessarily do well when inflation runs high, because inflation distorts the cost of capital, the value of inventories, and the discipline of management. Graham's view is that equities earn their inflation-hedge reputation only when the investor buys them at reasonable valuations. A common stock bought at twenty times earnings is not an inflation hedge; it is a speculation on multiple expansion. The investor who buys equities as an inflation hedge must apply the same valuation discipline to equities that he applies to bonds, or the hedge fails. Graham's inflation chapter is, in this sense, a precursor to the valuation discipline that the rest of the book develops. The chapter's most enduring practical advice is that the investor should hold both bonds and stocks, and rebalance between them at the policy weight that suits his temperament. Graham's default policy weight is fifty-fifty, with rebalancing back to that weight when the actual allocation drifts beyond a five-percent band on either side. The fifty-fifty rule is not a forecast of the relative attractiveness of stocks and bonds at any moment; it is a mechanical discipline that forces the investor to take profits in whatever asset class has run up and to redeploy into whatever asset class has fallen behind. The discipline converts the investor's natural aversion to selling winners and buying losers into an enforced, scheduled, and unemotional practice. Graham's chapter on inflation, read in full, is less a forecast about prices than a structural argument for a balanced portfolio rebalanced on a schedule, with valuation discipline applied to each asset class within the policy bands.