Benjamin Graham on Mistakes & Learning

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.

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 the memoirs Graham writes at length about his parallel career as a teacher, first at Columbia and later in his own programmes and seminars. He treats the classroom as a check on his investing — the discipline of explaining a method to intelligent laypeople forces the analyst to strip out the unexamined assumptions. Graham writes that several of his best ideas were sharpened by the obligation to make them defensible to students who were not yet captured by Wall Street convention. Graham's pedagogical principle was to teach the analytical method, not a list of conclusions. He refused to recommend specific stocks, refused to share his current portfolio, and insisted that students do their own security analysis. He treated the temptation to follow the guru's tip as the chief obstacle to becoming a real analyst; the analyst who copies a teacher's portfolio has learned nothing, while the analyst who replicates the method has learned everything. The memoirs record Graham's view that his most successful students — including the ones who later ran their own funds — were not necessarily the ones with the highest grades, but the ones who internalised the discipline of acting only when the analytical case was clear and the price was favourable. Graham writes that the teaching career was the part of his professional life that gave him the most durable satisfaction, because the methods survived the markets that produced them.

HIS EARLY LIFE Benjamin Graham was born on l\1ay 9, 1894 in London, the youngest of three children, all boys. His father wa~ in the family business of importing china and bric-a-brac from Austria and Germany. When he was just a year old, the family moved to New York to open an American branch of the firm. Ben began the normal life of a boy in New York, attending P.S. 10 at 117th Street and St. Nicholas Avenue. His father died at only 35, leaving his widow to bring up three boys ages 9, 10, and 1l. Various efforts were made to continue the business but, without an active adult, it failed in little more than a year. Nor did his mother's two-year experiment running a boarding house prove any more successful. When Ben was 13, his mother opened a margin account to buy an odd lot of U. S. Steel. The panic of 1907 wiped out the smail margin account. This was Ben's first contact with the stock market. Despite dwindling family resources, Ben graduated near the top of his class at Boys High School in Brooklyn. A clerical error delayed his scholarship to Columbia for one semester. The need to help support the family forced him to drop his daytime classes to take a full-time job with United States Express. Yet, he continued his studies with such great success that he graduated second in the Class of 1914. During his final month at Columbia, three departments-Philosophy, Mathematics, and English-each invited him to join their faculties as an instructor.

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.

Graham's 1976 La Jolla interview, conducted by Hartman L. Butler Jr. about a year before Graham's death, is the document in which Graham reflected most candidly on his career, his analytical method, and the changes he had made to his method in the light of the experience of the postwar decades. Graham tells Butler that he had, by 1976, simplified his analytical method substantially, and that the simplified method rested on the acquisition of a diversified portfolio of undervalued common stocks selected by a small number of quantitative screens. Graham's instruction is that the simplified method had produced returns at least as good as the more elaborate method he had applied through the Graham-Newman years, and that the individual investor who applied the simplified method would, over a long horizon, do at least as well as the more elaborate method had done for the partnership. Graham's discussion of the GEICO position is the interview's most instructive passage. Graham tells Butler that the partnership had bought half of GEICO in 1948 for about seven hundred and twenty thousand dollars, that the SEC had forced the partnership to distribute the stake, and that the distributed stake had subsequently been worth over a billion dollars in the public market. Graham is candid that the magnitude of the GEICO re-rating exceeded even the partnership's analytical expectations, and that the partnership had not, at the time of purchase, fully appreciated the operating leverage of the insurance-underwriting model that GEICO's direct-to-consumer distribution had produced. The interview's instruction is that the GEICO position was, in retrospect, the partnership's most consequential single investment, and that the partnership's analytical method had been sufficient to identify the position's margin of safety at the time of purchase, even though the subsequent re-rating had exceeded the analytical forecast. Graham's discussion of the 1929 crash is the interview's other instructive passage. Graham tells Butler that he had been running an investment account with margin leverage when the crash began, and that the wipeout had been severe even though Graham had been cautious about speculation by the standards of the era. Graham's instruction is that the experience of 1929 through 1932 had been the formative financial event of his life, and that the experience had taught him the discipline of avoiding leverage and the discipline of buying only with a margin of safety. The 1976 interview is, in this sense, the document in which Graham's most candid reflection on his career is recorded, and it is the document on which subsequent generations of value analysts have drawn for Graham's most direct statements on the lessons of his own experience. The interview is also the document in which Graham's revised view on the simplification of his analytical method is most directly recorded, and it is the document that grounds the simplified quantitative methods later generations of value analysts have applied.

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.

HB: By some coincidence as you were becoming less active as a writer, a number of professors started to work on the random walk. What do you think about this? Graham: Well, I am sure they are all very hardworking and serious. It's hard for me to find a good connection between what they do and practical investment results. In fact, they say that the market is efficient in the sense that there is no particular point in getting more information than people already have. That might be true, but the idea of saying that the fact that the information is so widely spread that the resulting prices are logical prices-that is all wrong. I don't see how you can say that the prices made in Wall Street are the right prices in any intelligent definition of what right prices would be. HB: It is too bad there have not been more contributions from practicing analysts to provide some balance to the brilliant work of the academic community. Graham: Well, when we talk about buying stocks, as I do, I am talking very practically in terms of dollars and cents, profits and losses, mainly profits. I would say that if a stock with $50 working capital sells at $32, that would be an interesting stock. If you buy 30 companies of that sort, you're bound to make money. You can't lose when you do that. There are two questions about this approach. One is, am I right in saying if you buy stocks at two-thirds of the working capital value, you have a dependable indication of group undervaluation?

The letters record that Graham-Newman's GEICO holding, although reduced by the SEC-mandated distribution, remained a meaningful position and a focus of the partnership's attention. Graham and Newman took board seats and involved themselves in the company's underwriting and finance. The letters describe GEICO's growth in premium volume and policyholder count, and note that the company's direct-to-consumer model was producing underwriting profits that other insurers could not match. The letters are explicit that Graham-Newman did not forecast GEICO's later dominance. The partnership's analytical case at the time of the 1948 investment was that the company was a low-cost operator with disciplined underwriting, in an industry where most operators were neither. The letters do not project the twenty-five-year outcome; they project a sound business bought cheaply. The lesson the partnership drew, in retrospect, was that soundness and price were sufficient and the growth bonus was a free rider. Graham-Newman's letters also disclose the moment in the early 1970s when GEICO's underwriting discipline broke and the company nearly collapsed. Graham writes, in later correspondence, that he had been retired from Graham-Newman by then and was not involved in the rescue, but that the episode confirmed his view that even a low-cost operator can be ruined by underwriting for growth rather than for profit.

The Rockwood case is one of several that Buffett worked on while employed at Graham-Newman between 1954 and 1956, and it is repeatedly cited as an instance where his analysis went beyond the partnership's standard arbitrage framework. Buffett's contribution was not the discovery of the arbitrage — the trade was widely known — but the recognition that the unhedged position carried the larger expected return. Graham-Newman's letters refer to the cocoa-bean operation in passing, treating it as one of many special situations. The lesson the firm drew was that arbitrage and workout opportunities recur in unusual corners of the market — reorganisations, exchanges, and recapitalisations where the catalyst is legal or tax-driven rather than operational. The firm's reporting discipline ensured that even the unusual cases were subjected to the same expected-return analysis as the standard ones. The Rockwood episode is also a record of the limits of the Graham-Newman framework as Graham himself understood them. Graham was willing to credit Buffett's analysis as a deviation that worked, and the memoirs and later interviews record Graham's view that some of his most successful students had moved past the strict Graham-Newman method into a more qualitative, business-focused style that Graham himself did not adopt. The Rockwood trade is a documented instance of the transition.