Geoff Gannon July 29, 2008

On Ben Graham, Bank Stocks, and Tom Brown

I wrote a response to Jason Zweig’s column on Ben Graham and bank stocks. Now, Tom Brown of has done the same. I have to admit, Tom’s article is better than mine. Both take Zweig to task for his explanation of why Ben Graham wouldn’t be a buyer of bank stocks today. However, Tom’s post does a better job of presenting the opportunities and challenges in analyzing bank stocks today:

Zweig’s premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution’s assets–particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock’s valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true.

Graham saw every investment as a black box – and that didn’t trouble him. A lot of investors spend a lot of their time worrying about the inner workings of the companies they own – Graham never did. He didn’t look inside the “system”, i.e. the company itself; instead he looked only at the outputs – the financial statements. He spent almost no time worrying about a business’s management, corporate culture, or future prospects. He didn’t worry about competitive advantages. He looked to the balance sheet first. When he moved on from there to consider earnings, his usual approach was to rely heavily on the past record in an attempt to discover what “normal” earnings might look like.

Graham was a rear view mirror guy. His margin of safety was based on making purchases at prices that would’ve worked well in the past. He liked sure things. For instance, he knew that NCAV stocks were sure things – and subsequent research continues to support that claim. I mentioned NCAV stocks in my previous post, because they are perhaps Graham’s most characteristic investment category. They combine elementary arithmetic and logic in a potentially lucrative but almost certainly safe investment operation. Also, unlike much of what he wrote about in The Intelligent Investor and Security Analysis, Graham actually made NCAV investments during his Wall Street career.

Before we can answer what Graham would do today, we need to know what he did do in his own lifetime. When writing about Graham, one needs to consider three separate categories: what Graham practiced, what Graham preached, and what Graham’s principles were.

What Graham Practiced

In the Intelligent Investor, Graham lists the five successful techniques his partnership employed from 1926 – 1956: arbitrage, liquidations, related hedges, net-current asset issues, and control investments.

Control Investments
Graham does not discuss control investments in any of his books; however, GEICO is a well-known example of a Grahamian control investment.

Buffett has discussed this techniques in some detail. See especially Buffett’s discussion of Berkshire’s purchase of Arcata shares. Both Buffett and Graham had stellar results in the arbitrage field, as Buffett explains in his 1988 letter to shareholders:

In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%.

That’s a long history of success. From 1926-1988, unleveraged arbitrage returns from Graham’s partnerships, Buffett’s partnerships, and Berkshire averaged better than 20% a year. Since some leverage was employed, actual returns over this sixty-three year period were even better than 20% per annum. Arbitrage works.

Liquidations are the simplest type of investment there is. You simply buy the stock below the expected final payout and wait for things to wind down. Buffett has invested in liquidations several times – most are not well-known. For a recent example, see Comdisco Holdings (CDCO). For a less recent example, see the Kaiser liquidation (from the 1970s).

Net current asset issues are not well-known, even today. However, the technique itself is well-known. Jonathan Heller of Cheap Stocks created an index to track (some) NCAV stocks. Since inception the Net/Net index has outperformed the relevant benchmark. However, it is a very young index.

Related Hedges
Related hedges are not appropriate for individual investors. They belong to a category of techniques that Graham employed with some success, but which have subsequently become far less fertile ground for investors, because modern theory and practice is better able to efficiently price a variety of more complex securities. Basically, Graham would go long a certain company’s convertible senior security and go short that same company’s common stock. If the stock rose, he would take a small loss. If it dropped sharply, he would make a nice gain. Obviously, these related hedges would provide a performance boost when the rest of Graham’s portfolio was struggling (since stock prices in general would be falling) and vice versa.

The first real coup of Graham’s career belongs to this category of mispriced special securities. Graham was a low-level employee of Newburger, Henderson, and Loeb when he brought up the idea of investing in the bankrupt Missouri, Kansas, and Texas Railway. The company’s bankruptcy plan gave owners of the old common stock the right (but not the obligation) to buy shares in the new company. This went mostly unnoticed at the time – or, if it was noticed, speculators were not using the old common stock as a way to play the new MKT. As a result, the old stock traded at just fifty cents. Graham figured that during a strong period for railroads the old common stock could easily rise three or four dollars – while the maximum loss on each share would still be just fifty cents. The firm bought into Graham’s idea and ended up making $15,000 on its $2,500 investment in less than a year (this was back in 1915 when $15,000 was real money – perhaps something like $300,000 today).

Graham’s partnership was a prototypical hedge fund. For starters, Graham actually hedged. He was short some securities and long others. For a while, he tried a basic long/short value approach, where he went long clearly cheap stocks and when short clearly expensive stocks. However, he found riding out the speculative surges in the stocks he was short to be an extremely unpleasant experience. He also found, over time, that he wasn’t especially good at finding stocks to short – certainly not good enough to get a better overall result (an investor has to be a lot more skilled at going short than going long to make it worth his while to short– if volatility and consistency aren’t as important to him as long-term results). Also, since Graham was always invested in an unusual mix of cheap stocks, liquidations, and related hedges, he was able to deliver rather consistent results without resorting to a more conventional long/short strategy. Eventually, Graham took the technique of shorting overpriced stocks out of his repertoire.

What Graham Preached

This is where Zweig comes in. Very little of what he writes has anything to do with what Graham practiced; generally, he writes about what Graham preached. These two things are quite different.


Graham liked rules, methods, and standards. Whether he was writing for professional security analysts or amateur investors, his goal was the same: to provide a practical, workable approach to the field of investments. He may have underestimated the common man; but, I doubt it. Even in The Intelligent Investor, he included a small section describing the actual techniques employed by his partnership. He also gave a separate set of rules for the enterprising investor to follow.

Graham didn’t divide investors by their risk appetite; rather, he divided them by their work appetite. Those who would work harder and be more businesslike – more like true professionals – would naturally come closer to the methods Graham himself employed.

So, if we were to use Graham’s own actions as our sole source for determining what he would do today, we’d have to say he’d invest in almost nothing that makes it into Barron’s, The Wall Street Journal, CNBC, or Bloomberg.

Graham would mostly do what he always did. There are still some NCAV stocks today; arbitrage still exists; liquidations still occur (e.g., I participated in what was essentially the liquidation of an Icahn controlled company last year – Atlantic Coast Entertainment Holdings, see Joe Cit’s post for details).

But, wouldn’t all of this be too small for Graham?

Yes and no.

No, Graham never needed big cap ideas, because Graham always kept his partnership small – much, much smaller than it could have been. He could have managed a lot more money; he was always much more famous than his assets under management would lead you to believe. He returned capital gains instead of allowing them to accrue in his favor. Overall, he tended to keep his operation very small by any standards – and infinitesimally so by the standards of today.

However, yes, Graham would need some other ideas. The most likely answer is that he’d rather change venues than change standards. Therefore, I doubt he’d be investing in even moderately pricey names in the United States whenever there were opportunities to buy ridiculously cheap stuff abroad. He’d probably have been in Korea after the Asian contagion; he’d certainly have been in Japan at some point, where there were some overcapitalized and underpriced public companies.

I know these aren’t exactly the most exciting answers. It’s a lot more interesting to argue over whether or not Graham would be buying bank stocks today than it is to consider what he’d actually be doing in modern times. My best guess is that if Graham were around today we’d consider him a very strange, very boring investor with a taste for odd and obscure securities in unappealing industries and out of favor countries.

Grahamian Theory

So where does that leave us regarding Graham and bank stocks?

All we have to go on are Graham’s principles. And this is where I think Zweig failed in his most recent column. His reasoning is all wrong. It paints an entirely inappropriate, almost stereotypically stodgy picture of Graham. Zweig confuses the conservatism of modern financial advisors with the conservatism of Graham. They are two very different things.

Graham would not have avoided bank stocks, because of falling real estate prices. He would avoid bank stocks, because there is an insufficient margin of safety (many are still trading above book value). He might demand a greater discount to book, because many banks have businesses and recent records built upon boom times. Graham always wanted to see how a business had performed under a variety of different circumstances, and this need for a solid past record would be even more important for banks, because of the nature of credit “cycles”. However, the mere fact that something unusual or even unprecedented is occurring in real estate and thus in financials would not have deterred Graham. His conservatism was not of that sort.

He could buy in the midst of the storm. He could catch a falling knife. Quite frankly, these weren’t his concerns. If a stock was sufficiently cheap and a business cleared a series of hurdles regarding its past performance and current financial position, Graham would buy it.

Zweig seems to be arguing that you can’t really know anything about a bank’s current financial position. When applied to Graham this makes little sense. Graham worked at a time when there was less disclosure and more fraud than there is today.

Consider the case of Northern Pipeline. The company provided investors with almost no financial data. Graham found the stock was trading for far less than the value of its investments per share by digging up the company’s filing with the ICC (Interstate Commerce Commission). Had he not done so, he never would have known. Most investors didn’t know.

While the balance sheets of banks may prove inaccurate (both on the way down and the way up), this wouldn’t have stopped Graham, because Graham always demanded a margin of safety. The precise financial condition of a bank becomes more important as it becomes more precarious. Likewise, the precise earnings power of a bank becomes more important the higher the multiple you’re willing to pay. But, if (as Graham would), you insist on both extraordinary financial strength and extraordinary cheapness, the importance of both concerns lessens. It never vanishes entirely. However, you can put yourself in a position, where your analysis can be more wrong than many analysts and yet your investment results can be better. The key of course, is to add a margin of safety everywhere. You have to start with a strong past record and then you have to buy it on the cheap.

That’s why I brought up Valley National (VLY). Not because I think it’s the best bank out there, but because I think it’s the sort of place Graham would start if he were going to apply his principles to bank stocks. He wouldn’t look for the fastest growing, highest quality company. He would look for the stodgiest bank he could find as shown by the bank’s past earnings history, as well as its credit quality, historical losses, etc. He wouldn’t be looking at the management – maybe he should – but he wouldn’t. Graham would be looking at the numbers. If ever a bank like Valley National were selling at two-thirds of book, then Graham’s principles would clearly allow the buying of a bank stock.

Now, you might rightly argue that Valley National is trading nowhere near two-thirds of book and might never do so, while other banks – lesser banks (in Graham’s eyes) – are trading at lower price-to-book ratios.

That’s true. And that’s where Buffett and Brown come in.

Buffett and Brown

When it comes to bank stocks, Tom Brown may be closer to Warren Buffett than Warren Buffett is to Ben Graham.


Graham did not specialize in financial service stocks. Tom Brown does. Warren – strictly speaking – doesn’t. However, he knows a great deal about them and has a long history with them. True, Buffett probably knows more about insurance than he does about banks, but his knowledge of banks is probably more useful to him as an investor. Let’s not forget, Berkshire once owned a bank.

Buffett’s partnership also owned banks at times. For instance, he had a large position (10-20% of his portfolio) in a New Jersey bank (Commonwealth Trust) back in 1958. He bought twelve percent of the bank at an average of five times earnings. Buffett conservatively estimated the bank was worth $125 per share. He ended up selling it for $80 per share (a 60% profit) to free up capital for the partnership’s large investment in Sanborn Map (a Northern Pipeline style investment).

Why bring up something Buffett did fifty years ago – when his more recent investments, like Berkshire’s purchase of Wells Fargo are more applicable to today?

Because, in 1958, Buffett’s approach was closer to Graham’s than it is today. Also, his description of the Commonwealth Trust investment better resembles the way Graham might think about bank stocks, if he were forced into that field.

Buffett’s Wells Fargo investment is further from the way Graham would have operated, if only because Buffett’s thinking had moved further from Graham’s over the years.

Buffett and Brown approach bank stocks very differently from the way Graham would have. They are more focused. They do more of a 360 degree analysis. They place greater emphasize on intangibles. There are a lot of differences.

They may have the better approach. It may be better to find the right stocks – even at today’s prices – than to look for the most statistically conservative stocks at the most statistically cheap prices.

Graham was ill-suited to investing in banks. However, Zweig’s reasoning isn’t right. In fact, it’s downright confusing for investors who know little of what Graham preached and what he practiced. Very few investors wouldn’t be deterred by the “perfect storm” in financials.

Ben Graham was one of the few who wouldn’t be.

Whether Graham would have invested in bank stocks or not, he would have made his decision based on past results and current prices – not real estate prices, or the credit climate, or any other macro-concern. At the right price, Graham would buy past earnings today assuming they would eventually materialize again tomorrow – and (as Brown says) the stocks might well bounce back first.

So, again, Zweig may be right about Graham not buying bank stocks. But, his reasons are all wrong.

Simply put, a smart guy wrote a stupid article.