Ben Graham is known largely for writing two of the most cited books in the field of value investing. Of course, in addition to being an outstanding writer and educator, he was a proficient practitioner of the investment field as well — a dual distinction that is extremely rare. In other words, he didn’t just preach, he practiced as well. And he did both at a very high level.
His investment record was excellent — he averaged gross returns around 20% per year in his Graham-Newman partnership. But he will always be most famous for his magnum opus, "Security Analysis," and its more “layman friendly” cousin, "The Intelligent Investor."
But he also wrote a third book that is rarely cited called "The Interpretation of Financial Statements." Probably because of the inherently dry nature of its contents, this book has remained largely unheralded.
He wrote "The Interpretation of Financial Statements" in 1937, after the first edition of "Security Analysis" and over a decade before "The Intelligent Investor."
It’s a very thin volume, and can be read easily in a weekend. I recommend picking up a copy and paging through it. As the title suggests, the book is mostly a tutorial on accounting and financial statements, and for those who don’t have an accounting background but are interested in the fundamentals of value investing, I definitely recommend this book.
I have always been interested in reading whatever Ben Graham had to say, regardless of how basic or how advanced the topic. I have owned this book for quite some time, and have flipped through it, but never really read it front to back. I brought it along on a trip last week and read it front to back, and thought I’d write a quick post with just a few quotes from the book.
As I said, most of the book revolves around the fundamentals of interpreting financial statements (again, hence the title), but there are a few spots where Graham hints at his underlying investment philosophy, which he covers in his other two books.
A Few of Graham’s Thoughts on His Investment Philosophy
Here are just a few interesting comments that portray how important Graham felt the earning power of a business was to its intrinsic value. In fact, if you just read these quotes without context, you might assume they were said by Peter Lynch or Phil Fisher. And remember, these words on the importance of earnings were written while still in the shadow of the greatest Crash in U.S. stock market history and during the Great Depression — this was not roaring '20s rhetoric.
So let’s invert, and read a few things Graham had to say about evaluating operating businesses and the importance of earning power:
“Outside of the field of banks, insurance companies and, particularly, investment trusts, it is only in the exceptional case that book value or liquidating value plays an important role in security analysis.”
“In the great majority of instances the attractiveness or the success of an investment will be found to depend on the earning power behind it.”
“Broadly speaking, the price of common stocks is governed by the prospective earnings.”
On Common Stock Prices, Values, and the Trend of Earnings
“Common stocks of enterprises with only slight possibilities of increasing profits ordinarily sell at a rather low P/E ratio (less than 15 times their current earnings); and the common stocks of companies with good prospects of increasing the earnings usually sell at a high P/E ratio (over 15 times their current earnings).”
“Obviously it is desirable that a company show a favorable trend in gross and net earnings” (Note: Graham refers to sales as “gross earnings” here).
“However, before purchasing a common stock because of its favorable trend it is well to ask two questions: (a) How certain am I that this favorable trend will continue, and (b) How large a price am I paying in advance for the expected continuance of the trend?”
On Book Value
“The book value of a security is in most cases a rather artificial value.”
“…if the company were actually liquidated the value of the assets would most probably be much less than their book value as shown on the balance sheet. An appreciable loss is likely to be realized on the sale of the inventory, and a very substantial shrinkage is almost certain to be suffered in the value of the fixed assets.”
Note: Warren Buffett must have not had this passage in mind when he bought Berkshire Hathaway in the mid-'60s for around 40% of its book value… see his 1985 Berkshire Letter for his mea culpa summary of how what he often calls “his worst investment” turned out.
“The book value really measures, therefore, not what the stockholders could get out of their business (its liquidating value), but rather what they have put into the business…”
On Intangible Assets
“In general, it may be said that little if any weight should be given to the figures at which intangible assets appear on the balance sheet. Such intangibles may have a very large value indeed, but it is the income account and not the balance sheet that offers the clue to this value. In other words, it is the earnings power of these intangibles, rather than their balance sheet valuation, that really counts.”
The Bottom Line
“At bottom the ability to buy securities—particularly common stocks—successfully is the ability to look ahead accurately. Looking backward, however carefully, will not suffice, and may do more harm than good. Common stock selection is a difficult art—naturally, since it offers large rewards for success. It requires a skillful mental balance between the facts of the past and the possibilities of the future.”
Note: This comment is interesting, because Graham was very much focused on “the numbers.” But again, something I’ve always felt is true — investing is not for the purely scientific. I love reading about “magic formulas” and other quantitative strategies, but personally have never felt comfortable handing over the keys to a strategy designed by computers and backtesting. I want more simplicity and greater understanding than those systems provide me with. I think the confluence of Schloss’ simplicity, Greenblatt’s focus, Buffett’s brilliance and Graham’s foundation is what has helped me mold my own ideas. It is part art, part science. And I think the best practitioners are the ones who are best able to combine both.
To Sum It Up
I found these comments interesting. Graham’s philosophy has always been synonymous with the “margin of safety” concept. And this extended to a focus on the balance sheet and stocks selling below their liquidation value. This represented one of Graham’s main investment strategies. But in his writing (here and also in his other books), he gives a surprisingly strong amount of weight to what he calls “The Earnings Record.”
He seems to say that while assets are important, it’s the earning power that truly creates value over time… sounds more like Buffett than Graham. This doesn’t exactly jive with his famous net-net strategy.
Why the Seemingly Contradictory Stance?
My take is this: I think Graham understood that a corporation’s earning power was the most important engine in driving value for its shareholders. Earnings, and the growth of those earnings over time, are what create true wealth for owners of any business. This became an ironic case study for Graham himself when he invested in GEICO, and made more money in that one business than all of his other thousands of individual investments combined throughout his career.
So despite the common perception of Graham being “balance sheet focused,” I think he truly understood the power and importance of the income statement, i.e. the earning power of a business.
Why then was he not focused more on “good” businesses like Buffett gravitated toward instead of the cigar butts that filled his portfolios? My guess is the scar from the depression was too great for him to overcome, and he could never get comfortable in making investments in good operating businesses where the price exceeded the net tangible asset value. This undoubtedly was an enormous opportunity cost to Graham, as the GEICO case exemplifies the power of a great operating business.
Nevertheless, it shows that both a balance sheet and an income statement focus can work, and overtime, I think that the art of combining both is the key to maintaining long-term superior results with a minimum of risk — and I think Graham agreed with this in theory.