Benjamin Graham on Management Quality

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.

As the president of an investment company himself, Graham answered the committee's questions about the industry with a candor his colleagues likely did not enjoy. He testified that most investment funds failed to justify their existence by their results, and that the investor in the average fund was paying management for performance he could approximate, or exceed, with a modest list of soundly financed companies bought at reasonable prices. Closed-end funds selling at discounts to their asset value were, in his account, a different matter — there the buyer obtained the underlying portfolio for less than its stated worth, a structural margin of safety that the open-end funds selling at premium prices could not offer. The testimony preserved in the transcript shows an operator willing to describe the economics of his own industry from the outside, including the parts unfavorable to it.

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.