Ben Graham Lecture Notes

I recently stumbled across collection of notes from Benjamin Graham’s lectures when he was a professor at Columbia University.

The notes were taken during lectures given in 1946, six years after the 1940 version of “Security Analysis” was published.

Actually, the name of the course was “Current Problems in Security Analysis”, and was, in Graham’s words an“attempt to bring our textbook ” Security Analysis” up to date, in the light of the experience of the last six years since the 1940 revision was published.”

Ben Graham: Still relevant

“The subject matter of security analysis can be divided in various ways. One division might be in three parts: First, the techniques of security analysis; secondly, standards of safety and common stock valuation; and thirdly, the relationship of the analyst to the security market.”

It has been nearly 70 years since Ben Graham gave these lectures, and clearly, the financial world has changed dramatically in this time. Nevertheless, the principles behind value investing remain the same however.

Graham starts his lecture by trying to get students to forget about stock prices. The analyst’s relation with the market should be, as Graham describes it, “that of a man toward his wife. He shouldn’t pay too much attention to what the lady says, but he can’t afford to ignore it entirely.

Straight off, Ben Graham is trying to draw a line between stock prices and the underlying business.

However, Graham then goes on to discuss the market and its movements. Specifically, the predictability of the market; it won’t go up forever but it also won’t go down forever.

“When you look at the stock market as a whole, you will find from experience that after it has advanced a good deal it not only goes down — that is obvious — but it goes down to levels substantially below earlier high levels. Hence, it has always been possible to buy stocks at lower prices than the highest of previous moves, not of the current move.”

“…if you look at this chart of the Dow Jones Industrial Average, you can see there has never been a time in which the price level has broken out, in a once-for-all or permanent way, from its past area of fluctuations. That is the thing I have been trying to point out in the last few minutes.”

Then Graham gets straight into the subject of security analysis.

Ben Graham – Security analysis

Ben Graham’s first analysis is that of a new issue, Northern Engraving and Manufacturing Company, which was looking to sell around 250,000 shares at $16 per share. That meant that this company was to be valued at $4 million in the market.

“Now, what did the new stockholder get for his share of the $4-million? In the first place, he got $1,350,000 worth of tangible equity. Hence he was paying three times the amount of money invested in the business. In the second place, he got earnings which can be summarized rather quickly. For the five years 1936-40, they averaged 21 cents a share; for the five years ended 1945, they averaged 65 cents a share. In other words, the stock was being sold at about 25 times the prewar earnings.”

Even by today’s standards, a valuation of 25 times historic earnings is excessive for a manufacturing company. But that’s not the whole story.

“But naturally there must have been some factor that made such a thing possible, and we find it in the six months ending June 30, 1946, when the company earned $1.27 a share. In the usual parlance of Wall Street, it could be said that the stock was being sold at six and a half times its earnings, the point being the earnings are at the annual rate of $2.54, and $16 is six or seven times that much.”

So, Northern was being offered at six or seven times forward earnings, which Graham notes, is unbelievable. What’s more, as Graham delves into the numbers (“we don’t stress industrial analysis particularly in our course in security analysis”) he determined that Northern Engraving’s profit margin was excessively high for the six-month period being used to value the company pre-IPO. Northern Engraving’s sales margins had jumped from 3% or 4% to 15%.

Ben Graham – Ignoring company specifics

Ben Graham goes on to give further valuation case studies, although he continues to ignore company-specific factors, such as management, brand power and reputation.

One long example, given at the end of the first lecture is a comparison of three different aircraft manufacturers and an analysis of their financial position as well as valuation.

The first company was named the Taylorcraft Company, with a market capitalization of $3 million, working capital of only $103,000, with stock and surplus of $2.3 million but $1.15 million of this was what Ben Graham called an “arbitrary plant markup”.

Also, Taylorcraft had serious financial issues. The company hadn’t issues financial reports for several years, which isn’t the sign of a financially sound company.

Additionally, the company arranged to sell its shares in an amount which did not require registration with the SEC. A four-for-one split was also undertaken to reduce the stock price to $3. Graham then considers another company, Curtiss-Wright:

“Taylorcraft and Curtiss-Wright apparently were selling about the same price, but that doesn’t mean very much…the Curtiss-Wright Company has built up its working capital from a figure perhaps of $12-million to $130-million, approximately. It turns out that this company is selling in the market for considerably less than two thirds of its working capital.”

“The Curtiss-Wright Company happens to be the largest airplane producer in the field, and the Taylorcraft Company probably is one of the smallest. There are sometimes advantages in small size and disadvantages in large size; but it is hard to believe that a small company in a financially weak position can be worth a great deal more than its tangible investment, when the largest companies in the same field are selling at very large discounts from their working capital. During the period in which Taylorcraft was marking up its fixed assets by means of this appraisal figure, the large companies like United Aircraft and Curtiss-Wright marked down their plants to practically nothing, although the number of square feet which they owned was tremendous.”

Curtiss-Wright had been sold off because investors were concerned about the company’s prospects after the war. However, investors were failing to take into account the company’s hefty land ownership, which had been written down to zero.

Of course, there was no guarantee that Curtiss-Wright’s prospects would improve, but the discount to working capital and fact that investors were missing the property opportunity gave a margin of safety.

A rough summary

This is just a rough summary of the first lecture in the series of ten Ben Graham archived lectures. If you’re interest in going through all ten articles, you can find them here.

Low Rates Are Not Good For Equity Returns

With the US economy showing signs of life, the Federal Reserve is widely expected to raise interest rates during 2015 for the first time since the financial crisis.

And the market seems to be terrified by the prospect of higher rates. The Fed’s easy money policies have propelled the market higher for much of the past six years, and investors are concerned that if the market loses this support, a correction will follow soon after.

However, there’s plenty of evidence that suggest the opposite will happen.

Interest rate hikes – Three studies

The first set of data comes from Ben Carlson, a portfolio manager for the endowment fund at the Van Andel Institute, a medical research center in Grand Rapids, Mich. This data was first published in The Wall Street Journal.

Carlson looked at the 14 periods during which the Fed was boosting short-term interest rates since the S&P 500 index’s inception during 1957. It was found that the average return during each period was 9.6%, including dividends.

Another study, this time from Northern Trust, a Chicago-based firm, once again published in the The Wall Street Journal, measured stock performance from six months before to six months after the Fed’s first announcement of a rate hike. 80% of the time, the market moved higher following an announcement.

And finally, a short study from J.P. Morgan Asset Management. JPM’s study showed that during the past two-and-a-half decades, when the Fed increased interest rates by 0.25% stocks fell slightly soon after but rebounded within a one to three months.

The most interesting and comprehensive data set on the topic comes from Credit Suisse Group AG (ADR) (NYSE:CS).

Interest rate hikes – Broad study

Credit Suisse’s Credit Suisse Global Investment Returns Yearbook 2013, an annual publication and highly recommended read, looked at the data from a study conducted by Elroy Dimson, a respected Professor and expert in market history and theory.

Elroy Dimson and his colleagues looked at the data for 20 different countries over a period of 113 years to see if there was any relation between higher interest rates and higher real equity returns. Within the period studied, there were 108 overlapping 5-year periods, giving a total of 2,160 observations — so the conclusions drawn from this data can be considered to be highly informative.

The 108 overlapping five-year periods were ranked from lowest to highest real interest rates and allocated into eight bands; the lowest 5% and highest 5% of real interest rates with six bands of 15% in between. As the chart below shows, the difference in returns across the data set is significant.

Market Performance after rate hikes Interest Rate

The real interest boundary plot show the boundary between bands. The bars are the average real returns on bonds and equities, included reinvested income over the subsequent five years within each band. A the investment yearbook notes:

“…the first pair of bars shows that, during years in which a country experienced a real interest rate below ?11%, the average annualized real return over the next five years was ?1.2% for equities and ?6.8% for bonds…As one would expect, there is a clear relationship between the current real interest rate and subsequent real returns for both equities and bonds. Regression analysis of real interest rates on real equity and bond returns confirms this, yielding highly significant coefficients.”

The highest band, when real interest rates averaged 9.6%, equity returns over the subsequent five-year period hit an annualized 11.3%. This is significantly above the mean annualized real return of the US equity market during the period 1900 to 2014. Over this period equities produced an average annualized real return of 6.5%; bonds produced a return of 2.0% and bills produced 0.9%.

Interest rate hikes – Reduced risk premium

By definition, the expected equity return is the expected risk-free rate plus the required equity risk premium, where the latter is the key unknown. Credit Suisse’s data shows that up until a decade ago, it was widely believed that the equity premium relative to bills was over 6.2%. It’s now believed that the equity risk premium is significantly lower. In the US at least during the period 1900 to 2014, according to the data above, the equity risk premium versus bills was 0.6% lower at 5.6%.

However, as Credit Suisse points out, as the US has been the world’s economic powerhouse over the past century, equity returns are bound to be higher than average. Excluding the US, the annualized historical equity risk premium versus bills stands at a lowly 3.5%. Including the US the global premium over bills stands at 4.1%.

Still, not all markets are created equal.

Market Equity risk premium vs. bills Equity risk premium vs. bonds
Australia 6.6% 5.6%
South Africa 6.4% 5.5%
Norway 3.1% 2.3%
France 3.0% 6.0%
Switzerland 2.2% 3.7%

Annualized equity risk premium 1900 to 2014.

Interest rate hikes: No need to fear a hike

All in all, the evidence suggests that investors have no need to fear an interest rate hike. The data suggests that while the market may suffer in the days and weeks following a hike, one to six months out, performance will start to improve and the market will push higher at a high single/double-digit clip.

Although, I should note that as always, past performance is not necessarily a guide to future performance.

Blind Valuation Test

Blind valuation one

Blind Valuaion  1

Blind valuation two

Blind Valuation 2

Blind valuation three

Blind Valuaion 3

The big reveal

I can now reveal the names of the three companies.

1. Gencor Industries, Inc. (DE) (NASDAQ:GENC)

A manufacturer of heavy machinery used in the production of highway construction materials, synthetic fuels, and environmental control equipment.

  • Current share price $9.64
  • Market capitalization: $91.80 million

2. Carriage Services, Inc. (NYSE:CSV)

Provider of death care services and merchandise in the United States. The Company operates in two segments: funeral home operations and cemetery operations.

  • Current share price $24.75
  • Market capitalization: $458.09 million

3. McRae Industries (OTCMKTS:MCRAA)

A manufacturer of boot products targeted to the western/lifestyle and work boot markets. The Company’s principal lines of business are manufacturing and selling military combat boots and importing and selling western and work boots.

  • Current share price $29.40
  • Market capitalization: $72.20 million

Clearly, these are all very different businesses, and, as a result, each one should be valued differently.


The responses were varied for the whole group, but, on the whole, a net-nets approach was the most favored method for valuing company number one. Responses ranged from $9.30 to $11.

Using Ben Graham’s formula for finding the net current asset value per share (Current Assets- Total Liabilities/Shares Outstanding), using only the figures supplied, Gencor’s NCAV per share stands at $9.295.

Rapid growth

Carriage Services is growing rapidly in a defensive, low-growth industry and is generating significant amounts of free cash flow. Over the past five years, the company’s revenue has expanded at a CAGR of 4.9%, net profit at 17.6% and free cash flow at 13.3%. Book value has grown at a CAGR of 10.7% over the period. Carriage is growing and becoming more efficient as it gets bigger. ROE has doubled over the past five years, and ROA has increased by 150%.

The one thing I didn’t note about Carriage is the fact that the company is a consolidator. The group has become extremely proficient at consolidating assets during the past few years. Therefore, there’s no reason why the company can’t continue to grow at the rate it has been since 2009.

Using a DCF analysis, based on Carriage’s current sustainable current free cash flow of $12.9 million, if the company’s cash flow continues to expand at 13% per annum for the next four years, before settling into a long-term growth rate of 10% and using a discount rate of 13%, which is higher than average but lower than the rate of 15% I’d usually use, we arrive at an implied valuation of $29.04. At this price Carriage would be trading at a historic P/E of 32.9, around the same as its closest listed peer, Service Corp International, which currently trades at a historic P/E of 32.8.

Answers for Carriage were extremely varied. They ranged from $9.42 to $25.18.


And lastly, blind valuation three, McRae Industries. Target prices for this stock ranged from $25.70 to $54.67 based on several different valuation metrics. The low-end valuation, $25.70 was based on McRae’s net asset value. Jeff Sciscilo submitted the higher price target using the following analysis:

1) BV in 2014 was $62.45M, we take a normalized ROE of 11.8% to get our normalized Net Income of $7.357M or $3.02 per share. We then multiply that by a mid-cycle normalized market multiple of 16x to get our price target of $48. In the current market and the growth of the company demand a premium of let’s say 20x normalized EPS, or $60. Assuming a required rate of return we get to $54.54/sh ($60/1.10) to get the price you would want to pay TODAY.

2) Due to a high period of current growth, extrapolating current revenue and net income growth rates is difficult. If we apply an H-model to normalized FCF using a short term growth rate of 20% (average of NI and Rev Growth rates) over the next 10 years and a terminal growth rate of 6% with a required rate of 10% you come to $54.67.

[From The Archives] Seth Klarman: The Value Of Not Being Sure

This article first appeared at

In February 2009, Seth Klarman wrote a piece for the Value Investor Insight publication entitled, The Value Of Not Being Sure.

The piece, written during the midst of the financial crisis, laid out Seth Klarman:’s trading strategy for the period of turbulence. And the article offered advice as to how investors should deal with the volatility. This information is relevant for today’s market as much as it was at the time.

Erratic Mr. Market

The first paragraph was titled: Erratic Mr. Market. Seth Klarman noted that at the time, the short-termism of the market had overwhelmed many market participants. As a result, trading had become erratic as investors’ time horizons dropped to days, rather than years:

“Time horizons have shortened even more than usual, to the point where the market’s 4:00 p.m. close seems to many like a long-term commitment. To maintain a truly long-term view, investors must be willing to experience significant short-term losses; without the possibility of near-term pain, there can be no long-term gain.”

Even today this is a relevant observation. As Seth Klarman goes on to note in his piece, for the value investor to remain committed, it necessary for him or her to take a long-term view and not become a day trader. What’s more, Seth Klarman cautions that market volatility is not the investor’s key enemy, in fact, it is the underlying economic situation.

“The greatest challenge of investing in this environment is neither the punishing price declines nor the extraordinary volatility. Rather, it is the sharply declining economy, which makes analysis of company fundamentals extremely difficult. When securities decline, it is crucial to distinguish, as possible causes, legitimate reaction to fundamental developments from extreme overreaction.”

The trouble of finding opportunities

Seth Klarman’s article was written around the time of the market’s lowest point in 2009. And there were plenty of opportunities for Seth Klarman and his hedge fund, Baupost to take advantage of.

However, the difficulty was finding the best opportunities, those companies that wouldn’t suffer from deteriorating economic fundamentals and the knock-on effect of falling security prices.

“In today’s market, however, where almost everything is down sharply, distinguishing legitimate reaction from emotional overreaction is much more difficult. This is because there is a vicious circle in effect (the reverse of the taken-for granted virtuous circle that buoyed the markets and economy in good times). This vicious circle results from the feedback effects on the economy of lower securities and home prices and a severe credit contraction, and, in turn, effects of a plunging economy on credit availability and securities and home prices.”

With the US economy in tatters, many households would feel the pinch and consequently, not all bargains were created equal. Still, as Seth Karlman goes on, many investors became forced sellers in a falling market, which in some cases inadvertently helped them achieved better outcomes than the value-oriented bargain hunters who bought from them. That said:

“Buying early on the way down looks a great deal like being wrong, but it isn’t. It turns out you won’t be able to accurately tell who’s been swimming naked until after the tide comes back in. AsBenjamin Graham and David Dodd taught us, financial markets are manic and best thought of as an erratic counterparty…f you look to “Mr. Market” for advice, or if you imbue him with wisdom, you are destined to fail. But if you look to Mr. Market for opportunity, if you attempt to take advantage of the emotional extremes, then you are very likely to succeed over time…if you regard stocks as fractional interests in businesses, you will maintain proper perspective. This necessary clarity of thought is particularly important in times of extreme market fluctuations.”

Baupost vs S&P Seth Klarman

Timing Mr. Market

Seth Klarman’s viewpoint throughout the article is that the market will recover over time, no matter how severe the downturn.

Baupost actually started buying distressed securities during 2008, fully expecting things to get worse before they improved:

“While it is always tempting to try to time the market and wait for the bottom to be reached…such a strategy has proven over the years to be deeply flawed…Moreover, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.”

In an uncertain environment — like that of 2008/09 — money managers must keep firmly in mind that the only things they can really control are their investment philosophy, investment process, and the nature of their client base. Therefore, a tight grip over investment process is required.

“Controlling your process is absolutely crucial to long-term investment success in any market environment.”

“When an investment manager focuses on what a client will think rather than what they themselves think, the process is bad…When the manager’s time horizon becomes overly short-term, the process is compromised. When tempers flare, recriminations abound, and second guessing proliferates, the process cannot work properly.”

Value investing is contrarian by its very nature and when taking a contrary approach, “one has to be able to stand one’s ground, be unwavering when others vacillate, and take advantage of others’ fear and panic to pick up bargains.”

Seth Klarman: The value of not being sure

Successful investing requires flexibility and open-mindedness. You can never be sure what the future holds for the economy or for your investments.

“Successful investors must temper the arrogance of taking a stand with a large dose of humility, accepting that despite their efforts and care, they may in fact be wrong…Those who reflect and hesitate make far less in a bull market, but those who never question themselves get obliterated when the bear market comes.”

And this is the value of not being sure. As Seth Klarman highlights, successful investors should always be ready to doubt themselves and admit that they were wrong. It is much harder psychologically to be unsure than to be sure; certainty builds confidence, and confidence reinforces certainty. Being overly certain in an uncertain, unpredictable, and ultimately unknowable world is hazardous for investors.

“To be sure, uncertainty breeds doubt, which can be paralyzing. But uncertainty also motivates diligence, as one pursues the unattainable goal of eliminating all doubt. Unlike premature or false certainty, which induces flawed analysis and failed judgments, a healthy uncertainty drives the quest for justifiable conviction. Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments.”

As a result, uncertainty helps you to become a better investor, pushing you to work harder and to be endlessly vigilant.

Warren Buffett The Early Years — Part Seven: Work-Outs

Warren Buffett The Early Years — Part Seven: Work-Outs

As covered in the last part of this series, Warren Buffett had three different types of investments when he was managing his partnerships. These three categories were: generals, workouts and control situations.

Workouts, or special situations (corporate events such as mergers, liquidations, reorganizations, spin-offs,) are by far the most interesting of this group.

Due to their nature, Buffett was able to predict what kind of a return he would generate from each workout, over a specified period of time, and to some extent, this reduced risk.

“The gross profits in many workouts appear quite small. A friend refers to this as getting the last nickel after the other fellow has made the first ninety-five cents. However, the predictability coupled with a short holding period produces quite decent annual rates of return. This category produces more steady absolute profits from year to year than generals do.”

Warren Buffett considered some of his workouts to be so low risk — Warren Buffett used the term “high degree of safety” — that he often borrowed money to increase returns.

In his 1962 letter to investors, Warren Buffett gave a detailed explanation of his workout plays undertaken during the year. And at the time, Buffett was finding deals in the oil sector. Specifically, sell-outs by oil producers to major integrated oil companies.

Warren Buffett: Borrowing to increase returns

At any one time, Buffett was involved in five to ten workouts. Some just beginning and others in the late stage of their development.

Continued at

From the Archieves: Walter Schloss Checklist

Walter Schloss was one of Benjamin Graham’s most successful students. From 1955 through 2002, Schloss returned 16% per annum, according to his own figures, successfully using Benjamin Graham’s net-nets strategy to outperform the market for five decades.

Walter Schloss didn’t give many interviews over his career, but he did write a number of memos and letters to various publications over the years.

Walter Schloss: Two Checklists

Checklists are an important part of investing. Some of the world’s best investors, including John Griffin of Blue Ridge Capital, Mohnish Pabrai, Charlie Munger and Schloss’ mentor, Benjamin Graham all used, and continue to use checklists to assess potential investments.

Walter Schloss produced two checklists over his life, (or two that have been published and are available for viewing).

The first list, was entitled, “16 Factors Needed to Make Money in the Market” and is something I’ve covered before, here.

Walter Schloss’ second checklist, was offered to students attending an upper level seminar in value investing at the Columbia Business School — undoubtedly the birthplace of value investing.

Titled, “What Kind Of Stocks Do We Look At For Investments?” the checklist outlined the key factors Walter Schloss considered before making a decision to buy a stock. Below is an excerpt from the checklist followed by a screen grab of the whole note.

What kind of stocks do we look at for investments?

  • We look for stocks that are depressed [Schloss liked to comb the paper for stocks hitting 52-week lows]
  • Why are they depressed
  • Are they selling below book value

  • Is good will in book value

  • What has been the high [/] low over the past 10 years?

  • Have they any cash flow?

  • Have they any net income?

  • How have they done over the past 10 years?

  • What is their debt level?

  • What kind of an industry are they in?

  • What are their profit margins?

  • How are their competitors doing?

  • Is this company doing poorly compared to its competitors?

We get their annual reports, proxies and valueline and quarterlies. What appears to be the risk on the downside vs. the upside potential?

How much stock do the insiders own?

schloss checklist

Rare Seth Klarman Article: Why Value Investors Are Different

On February 15, 1999, Barron’s magazine published an opinion piece entitled, Why Value Investors Are Different. The article looked at one of the most important periods of Warren Buffett’s career and was written by none other than Seth A. Klarman.

As usual, Seth Klarman’s insights are invaluable. So, here are some key takeaways from the article.

Seth Klarman: Why value investors are different

Seth Klarman begins his piece on Warren Buffett with the following statement:

“The most dramatic and valuable lesson from the fabulous (and still counting) 50-plus-year investment career of Warren Buffett is the legendary account of his steadfast conviction amidst the 1973-75 bear market. He had correctly identified by 1973 that the shares of companies such as the Washington Post were selling for but a fraction of underlying business value represented by those shares.”

[A side note: The discounted value of the Washington Post’s shares was discussed in Warren Buffett’s famous essay, ‘The Superinvestors of Graham-and-Doddsville’.During 1973, The Washington Post Company had a market capitalization of $80 million. However, the figures showed that the company’s assets were worth $400 million, probably appreciably more according to Buffett.]

The stock price of the Washington Post continued to decline over the next two years, through 1975. But Warren Buffett kept buying. Roger Lowenstein later wrote in his biography of Warren Buffett:

“[the] impression of Buffett sweeping down the aisles of a giant store [buying stock]…As the market fell, he raced down the aisles all the faster.”

Seth Klarman

Studying behavior

Seth Klarman notes that studying Warren Buffett’s behavior during this period is extremely important for investors. He writes:

“…it powerfully evokes the memory of what happens in bear markets: Good bargains become even better bargains. It is also important testimony to the wisdom of staying power: Had Buffett worried about the interim losses in 1974 or 1975 from his earlier and more expensive purchase of Washington Post shares, he might have…panicked or been forced out…”

Here, Seth Klarman goes on to write about something that’s not usually mentioned when talking about Buffett nowadays; his human nature.

It’s easy to forget that Buffett is indeed human, not an invincible super investor that can do no wrong — even though this is the image that he gives off. What must Buffett have been thinking during the bear market of the early 70s when most of his stocks were falling? Seth Klarman writes:

“…the well-founded conviction a value investor is able to have, confidence in the margin of safety that a bargain purchase is able to confer…he [Buffett] simply decided that the market was wrong. His view was that the sellers were not thinking clearly…Their disagreement, if there was one, concerned the level of appropriate discount between share price and business value, a gap that Buffett saw as widening.”

What’s more:

“He didn’t worry about whether the stock was about to split or pay or omit a dividend. He most certainly did not evaluate the stock’s beta or use the capital-asset pricing…he simply valued the business and bought a piece of it at a sizeable discount.”

Seth Klarman then goes on to talk about the perception of risk. Was Buffett worried about risk? Of course, but as Klarman notes, Warren Buffett’s perception of risk is not the same as the short-term fund manager, who is worried about short-term underperformance. Instead, Buffett’s description of risk is the permanent loss of capital. And with that being the case, the best way to reduce risk is to try and buy a dollar for only $0.50.

This article was originally published on Part two can be found here.