Benjamin Graham on Shareholder Orientation

ABOUT the AUTHORS Irving Kahn, C.P.A. Irving Kahn was an early student and then assistant to Benjamin Graham at the Columbia University Graduate School of Business and the New York Institute of Finance. He is a founder of the New York Society of Security Analysts and serves as an Associate Editor of the Financial Analysts Joumal. He is stilI active as an investment advisor at Lehman Brothers in New York. Robert D. Milne, C.P.A. Robert Milne is a partner of Boyd, Watterson & Co., investment counselors. He is a past President of The Institute of Chartered Financial Analysts. He is Vice President of The Financial Analysts Research Foundation, serves as a member of the Editorial Board of The G.F.A. Digest, and is an Associate Editor of the Financial Analysts Jom"nal. He is a past President of the Cleveland Society of Security Analysts. Mr. Milne received his B.A. degree from Baldwin-Wallace College and his J.D. dgeree from the Cleveland-Marshall College of Law of Cleveland State University. He has written a number of articles for professional publications, and is a member of the Ohio Bar. ix

One of his earliest studies was an analysis of the Missouri Pacific Railroad. Its report for the year ended in June 1914 convinced him that the company was in poor physical and financial condition and that its bonds should not be held by investors. He showed the report to a friend who was a floor broker on the Exchange. The floor broker in turn showed the report to a partner In Bache & Co. As a result, Ben was asked to become a "statistician"-as security analysts were then called--at a salary of $18 per week, a 50 percent raise. Ben assumed that Newburger, Henderson & Loeb would not object, as he had brought in no bond commissions to offset his salary. Samuel Newburger Instead was outraged that his employee could be so disloyal as to consider leaving. To his surprise, this conversation ensued: "But, I thought I wasn't earnmg my salt here." "That's for us to decide, not you." "But I'm not cut out for a bond salesman; I'd do better at statistical work." "That's fine. It's time we had a statistical department. You can be it."

sympathetically allowed Ben to make up the deficiency at $60 per month. After two years the market strengthened sufficiently to make up the deficiency, and in later years Ben was able to build up Professor Tassin's fortune to a "quite respectable figure." During the war years Ben submitted to the Magazine of Wall Street an article entitled "Bargains in Bonds." This was a thorough study showing the disparities among the prices of a number of quite comparable issues. From then on, he became a frequent contributor to the magazine. At one point he was asked to join the staff and later he was asked to become editor with an attractive salary. Mr. Newburger again talked Ben out of leaving the firm, this time promising him a junior partnership. Instead, Ben's brother, Victor, became an advertising salesman for the Magazine of Wall Street, where he had a great success, becoming the vice president in charge of the department. THE NEW ERA BEGINS Between 1919 and 1929, Ben's upward progress in Wall Street was so rapid as to verge on the spectacular. At the beginning of 1920 he was made a partner in N ewburger, Henderson & Loeb, retaining his salary and gaining a 2Y2 percent interest in the profits, without any liability for losses. One of Ben's friends was with the important public utility bond house, Bonbright & Co. He introduced Ben to a young man, Junkichi Miki, who had tried to interest Bonbright & Co.

Western markets, selling at a substantial discount. As the Japanese had no prejudice against these bonds, his back office was inundated with reams of documents. The typical purchase of $100,000 face amount would usually result in the appearance of one thousand separate bonds. The special safe deposit box for these bonds was known, not too favorably, as the "Ben Graham" box. After two years, the Fujimoto Bank set up its own New York office, with Miki in charge, to buy these bonds. Two other Japanese banking firms then became customers and made up for some of the lost business. Ben's main work was in handling an inquiries about security lists or individual issues. He was given an assistant, Leo Stern, later a senior partner in the firm and the father of Walter P. Stern-whose own distinguished career has included terms as President of The Financial Analysts Federation and of The Institute of Chartered Financial Analysts. Periodically, they issued "circulars" analyzing one or more securities in detail. For example, in May of 1921 they recommended the sale of the U. S. Victory 4%'s due in 1923 and selling at 97% and reinvestment in the U. S. 4%'s of 1938 then selling at 87Y2. They believed that the then high level of interest rates would subside and thus the longer term bonds had better appreciation po~sibilities. This circular was advertised in the newspapers under the title "Memorandum to Holders of Victory Bonds."

operation was the purchase of convertible bonds near par value and the simultaneous sale of calls on an equivalent amount of common. At times the market would be stronger for puts and then the bonds would be bought, the stock sold short and a put also sold. As the premium prices then received for puts and calls were substantial, this procedure guaranteed a satisfactory profit no matter whether the stock rose, fell, or remained constant. The postwar bull market of 1919 was a typical bull market of the times-marked by manipulations by insiders, plus the usual greed, ignorance, and enthusiasm on the part of the public. Ben came through the dangerous period of 1919-1921 quite well, remembering his experience with the Tassin account. His accounts concentrated on arbitrage and hedging operations. One of the speculative favorites of the time was Consolidated Textile, a recent conglomeration of cotton mills whose convertible seven percent bonds appeared sufficiently safe to buy. Later, as the common rose in price, corresponding amounts of stock were sold short, assuring a good profit. One of the firm's senior partners, an enthusiastic bull on the stock, had purchased large quantities of the common for his customers. Ben pointed out that the convertible bonds had the same potential for profit as the stock, plus less risk of loss. The partner said his customers liked an active stock rather than a bond.

substantial companies, however, fell outside these favored categories and sold at bargain-counter prices, even below their minimum values as judged by ordinary standards. Among these were Plymouth Cordage, Pepperell Manufacturing Co., and Heywood & Wakefield, the leader in the baby carriage industry, each selling below working capital. Bernard Baruch bought substantial amounts of these issues, confirming the soundness of Ben's analyses. Baruch egotistically believed that his concurrence was a sufficient reward for Ben's efforts. Both agreed that the market had advanced to inordinate heights and, with such frenzied speculation, it would ultimately end in a major crash. Baruch commented that it was ridiculous for short-term interest rates to be eight percent while the Dow Jones Industrials provided only a two percent yield. Ben replied: "By the law of compensation, someday the reverse should happen." Some years later after the crash when the law of compensation took effect, Ben realized that it was strange that, despite his accurate projection, he did not realize that all operations involving borrowing, including his own, would be affected by the ultimate collapse. One day in 1929, Baruch invited Ben to his office. For the first time in his life he wanted a partner. "I'm now 57 and it's time to slow up a bit and let a younger man like you share my burdens and my profits."

Although this was most gratifying to one's ego, Ben had just completed a year in which his personal net profit was over $600,000 and thus saw no reason to be a junior partner even to the eminent Bernard M. Baruch. THE DELUGE The Benjamin Graham J oint Account began with $450,000 at the start of 1926 when the Dow Jones Industrial Average was 157. In 1926, the Dow had only a nominal gain, but 1927 provided an encouraging 32 percent return. The Benjamin Graham Joint Account ended that year at $1,500,000, with new capital coming into the account, as well as capital gains. The year 1928 was the last full year of the bull market, with a 51 percent return for the Dow Jones Industrials and a 60 percent return for the Joint Accoun t, after Ben's share that exceeded $600,000. This excellent record led to an even more exciting proposal, one to manage a large new investment trust. Many major investment trusts were formed in the 1920's. The first were fixed trusts with a specified and fixed portfolio of common stocks, with the shareholder holding a pro rata share in this unchanging list. Actually, this was really not greatly different from the index funds of today.

Analysis presented a well-reasoned and well-organized case for the great investment opportunities then open to those competent to learn its teachings. Typical of Ben's wide erudition and sense of the timeless qualities of great philosophy is its opening quotation from Horace: "Many shall be restored that now are fallen and many shall fall that are now in favor." It is beyond the scope 0 l' this biographical sketch to examine all the original and radical concepts outlined in this pioneering book, most of which have become so well accepted that it is difficult to imagine why they once were not obvious to the entire investment community. EARNING A LIVING The halcyon days of 1928, when Ben's share of the Joint Account's profits exceeded $600,000, were long past. Because their unique profit sharing arrangement was a cumulative one, Ben and Jerry Newman went five years without any payment for their work. Because of the drastic price decline, the fund's capital would have to triple before they would be eligible to start sharing again. One partner suggested a revision be made and, following discussion with some of the larger investors, the terms were revised, reducing the share of Ben and Jerry to a straight 20 percent of profits earned after January 1, 1934. By the end of 1935, all past losses had been made good.

purchase. Ben began to test this new approach in a modest way with some California friends. While death brought this phase of his research to an end, it nonetheless did show his continued devotion to research as displayed so well in Security Analysis and The Intelligent Investor. Irving Kahn arranged a memorial service for Benjamin Graham at the Chapel of Columbia University. A hundred old and dose friends of Ben attended-his partner Jerome Newman, Columbia's President, William McGill, David Dodd, Professor James Bonbright, Ben's colleagues for half a century, and many from the investment and academic communities. Friends from other areas of his life also attended. A group of ten blacks from the Mt. Zion Baptist Church of Bridgeport, Connecticut gave homage to the stranger who made it possible for them to worship in their own church. Ben's life has affected many. All financial analysts owe so much to the pioneering efforts and works of BenjaminGraham-~truly,the Dean of our profession.

The Graham-Newman letters to shareholders, written between 1946 and 1958, lay out a stable operating policy: the partnership purchased securities at prices below their intrinsic value as measured by asset coverage, earning power, or contractual claim, and sought to realise the discount through liquidation, distribution, or market re-rating. Graham-Newman classified positions into three buckets — undervalued common stocks, special situations with a catalyst, and arbitrage or workout positions with a defined timeline. The letters record that Graham-Newman pursued each bucket with a distinct discipline. Common stocks had to trade at a discount to net current assets or to conservatively capitalised earning power; special situations required an identifiable catalyst such as a merger, recapitalisation, or litigation resolution; arbitrage positions required a small gross spread per unit but a high annualised return because the time to resolution was short. Graham-Newman reported the three buckets separately to shareholders so the sources of return could be tracked. Graham-Newman's reporting discipline is itself a contribution of the letters. The partnership did not simply report aggregate return; it reported the components of return by category, the realised and unrealised portions separately, and the net asset value per share on a transparent mark. This reporting standard, well before the modern hedge-fund era, made the partnership's record auditable and reproducible — a discipline Graham regarded as part of the analyst's obligation to his capital.

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.

The 1949 Graham-Newman annual report, the partnership's report for the year ended January 31, 1949, was the first full-year report the partnership issued after the SEC's distribution of the GEICO position that Graham-Newman had acquired in 1948. The distribution is the report's most consequential event, and Graham-Newman's discussion of it is the report's most consequential passage. The partnership had been forced by the SEC to distribute the GEICO stock to its own shareholders, because a technicality in the Investment Company Act prohibited an investment fund from holding more than ten percent of an insurance company. The distribution, the report notes, was a forced consequence of regulatory structure rather than a free investment decision; the partnership did not sell the GEICO stake because it wanted to, but because the regulator insisted on the distribution as the price of the partnership's continued operation as a registered investment company. The report's discussion of the GEICO distribution is also the report's most analytical passage. Graham-Newman records that the cost basis of the GEICO stake was approximately seven hundred and twenty thousand dollars, that the distributed value was many multiples of that cost, and that the partnership's shareholders received, in the distribution, a stake whose market value ran into the hundreds of millions of dollars over the subsequent decades. The 1949 report does not forecast the future value of the distributed stake; the analytical point Graham-Newman makes is narrower. The partnership's investment method had identified, in GEICO, a security whose intrinsic value was substantially above the price the partnership had paid for it. The margin of safety the partnership had demanded at the time of purchase was the analytical basis on which the subsequent re-rating could occur, and the report is candid that the magnitude of the re-rating exceeded even the partnership's analytical expectations. The 1949 report also develops the categorization of the partnership's positions that Graham-Newman would use in every subsequent year. The partnership's holdings are divided into three categories: undervalued common stocks held for the market's re-rating of the underlying value; special situations held for a defined catalyst such as a merger, reorganization, or liquidation; and arbitrage positions held for a defined closing such as the completion of a tender offer or the settlement of a recapitalization. The categorization is the report's analytical contribution to the discipline of reporting: it allows the partnership's shareholders to see where the partnership's returns are coming from, and it gives the partnership's auditors a verifiable map of each position's expected catalyst. The 1949 report is, in this sense, the document in which Graham-Newman formalized the working method that the partnership would carry through the rest of its life and that subsequent generations of value partnerships would adopt as their own working discipline.

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.

Graham's nineteenth chapter takes up the question of what corporations owe their shareholders in cash, and when the cash should be distributed rather than reinvested. Graham's starting position is that the dividend is the shareholder's most reliable return. The capital gain is uncertain; the dividend, once declared, is paid in cash and reaches the shareholder's account on the schedule the company has promised. Graham's view is that the company that earns more than it can productively reinvest should distribute the surplus to its owners, and that the company that retains earnings without a credible reinvestment plan is, in effect, confiscating the owner's share of the cash flow. The dividend is, in this sense, the test of whether the company's reported earnings were real: earnings that never become dividends, over a long enough period, are earnings that the shareholder has not actually received. Graham is aware that some companies can reinvest retained earnings at attractive rates of return, and that for those companies a low payout ratio is the right policy. The test Graham proposes is the rate of return the company earns on the retained earnings, compared with the rate of return the shareholder could earn if the same cash were distributed. If the company can earn a higher rate on the retained earnings than the shareholder could earn on the distribution, retention is justified; if not, distribution is. Graham's instruction is that the company should justify its retention of earnings by demonstrating, over a period of years, that the retained earnings have produced a return at least as high as the shareholder's alternatives. Companies that retain earnings without that demonstration are, in Graham's framework, paying the shareholder in promises instead of in cash, and the shareholder's eventual return will reflect the difference. Graham's most pointed advice is that the investor should be skeptical of management's claim that retained earnings are being reinvested productively. The claim is, almost by definition, self-serving; the manager who retains earnings is also the manager who benefits, through compensation and perquisites, from the larger balance sheet that retention produces. Graham's prescription is that the investor should look for companies with a long record of paying dividends through the cycle, and should treat the dividend record as a constraint on management's temptation to retain. A company that has paid a dividend through a full cycle, and has raised the dividend over the period, has demonstrated a discipline that the non-dividend-paying company has not. The nineteenth chapter is, in this sense, an argument for the dividend as a governance instrument as well as a return instrument: the company that pays the dividend is the company whose owner-friendly posture is documented in the cash-flow statement, and not merely asserted in the chairman's letter.

The 1948 Graham-Newman annual report, preserved in the Columbia Business School archive, sets out the partnership's reporting discipline. The report carries an audited balance sheet as of January 31, 1948, a profit-and-loss statement, and a statement of unrealised appreciation. The partnership distinguishes realised from unrealised gains explicitly, and reports net asset value per share to the dollar. The reporting discipline is itself an analytical contribution. Graham-Newman did not bury losses in unrealised accounts, nor did it report gains before they were realised. The separation of realised and unrealised returns allowed shareholders to see what the partnership had actually earned by closing positions and what it carried in mark-to-market on open positions. The discipline foreshadowed the modern hedge-fund reporting standard by several decades. The 1948 report also confirms the partnership's holdings in three categories: undervalued common stocks held for market re-rating, special situations held for a catalyst, and arbitrage positions held for a defined closing. The categorisation let shareholders assess where the partnership's returns were coming from, and gave the partnership's auditors a verifiable map of each position's expected catalyst.