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A Lesser Known Gem by Ben Graham

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 US Stock market history and during the Great Depression—this was not roaring twenties 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-60’s 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 (it’s 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.

16 thoughts on “A Lesser Known Gem by Ben Graham

  1. John,

    Good find. I read this one a year or so ago and I was surprised as you were to find it wasn’t just about analyzing financial statements but also carried a lot of Graham’s investment thinking.

    To tie everything you said together, and this is a point Buffett has raised, all we’re really trying to do at the end of the day is turn everything we analyze into a bond of some type and figure out:

    1.) What are the coupons?
    2.) How often?
    3.) How confident are we that we’ll get them?

    If our “bond” can’t generate coupons with reliability, it isn’t worth much and certainly not par in most cases.

    So that, in my mind, is why he was so “focused” on earnings despite the reputation as a balance sheet guy. He was looking at companies, as Buffett eventually learned to, as “bonds” whose coupons were variable and the art of it was trying to figure out that variance in a systematic way.

    The reason the balance sheet is still valuable is, as you said, it potentially provides a margin of safety so that if you missed the coupon calculation, you can still get back the “par value” of the bond. And, the balance sheet has clues as to how the bond performed in the past… for example, large and growing retained earnings suggests the bond had a lot of coupons, and vice versa. Finally, it can give you a sanity check. If you think your bond is going to issue an X% coupon, you can look at the balance sheet and see if that kind of return is sensible given the size and mixture of assets.

    1. You are exactly correct. So few have figured this out. Investors must value stocks like bonds. DCF models to infinity have little value. What matters is what an owner of the entire company will put into his bank account (or choose to reinvest) over a period of time compared to what bonds will pay. Earnings power PLUS liquidation value. The math is simple, the forecasting of the future is difficult. Having in-depth knowledge of the company, management, and competitors is what makes the math easier.

  2. Good write up.

    I would add one other reason: earning assets derive their value from the earnings they can produce. That means that looking at the past earnings and making a judgement about the future are key to a good asset valuation.

    I have seen this book on Amazon but I always assumed like it would be a book about outdated accounting. How much does the book focus on accounting rules/techniques that are no longer relevant?

    1. Thanks Evan. Yeah I had that same general thought–although I bought the book a long time back, it just sat on my shelf. I had some time so I picked it up and read through it, and I found it to be quite relevant. There are a few things that have changed, but surprisingly most of the book can be applied today. Some of the accounting terms themselves are outdated, but overall, it’s a good book. If you already know accounting, it will be a very quick read. For those that don’t know accounting, it is a good intro primer. But I like reading anything Graham wrote, because even though the majority of the book is about financial statements and accounting, his philosophy comes through in his writing. It’s worth a read, and it won’t take long. You could read it in an afternoon…

  3. Thanks for this website.

    I am new to investing. I understand basic accounting. Equity bonds? Gotcha. (Thanks valuePrax for that amazing post) Financial terms gotcha.

    How to read a balance sheet, income statement, and cash flow statement? Gotcha. I know some basic red flag stuff like a/r shouldn’t exceed sales, depreciation shouldn’t exceed ccapex, etc. EBITDA – capex = EBIT

    Then there is the complicated stuff that I can’t wrap my head around.

    Do you have a checklist to get rid of accounting fraud risk? What are your thoughts on a person who has a basic understanding of accounting but not like the way munger has a mastery over it. Do you suggest on learning accounting on a deeper level? I’ve half way into Ben graham’s book and boy did it change my views on him.

    Also – can you post your VIC writeup? I highly admire your blog (and you really are a rising value investor. Love the combination of greenblatt, schloss, and buffett. Makes me think of my investment strategy real deeply) Could you share your writeup that allowed you to enter VIC – I think it would be a great learning experience to the readers of this blog, of your investment style being articulated in a condensed format.

    Having read the Charlie writeups and the santangel review article – wow is this guy amazing. Makes me want to clone his approach (Pabrai anyone? He is also a genius!) his nvr writeup is simple..

    Having read about your style. The way I see it is this – you have a graham+greenblatt/buffett approach. You look for value whether it is through assets or earnings. What I don’t understand is your work in strayer education (this one popped in the magic formula screen) and Barnes and nobles. These aren’t businesses with high roc+cheap, which is in the greenblatt department. Barnes and nobles is a special situation with the thesis being that the unprofitable business being shut down. It isn’t a greenblatt investment but a business that is cheap relative to cash flows. Are you just looking for the gap between price and value with these investments? For me I’d invest in a basket of asset investments and concentrate on investments like CBOE when they get cheap enough (50% roc is really attractive and digging a little further – it is effectively a mini monopoly with a clean balance sheet. (Much more work to be done though.

    Are you looking for cheap anything? And when the fat pitch comes, you will pounce? What confuses me is your earning investments. Can you clarify in detail?

    Thanks again for this website Mr. Huber and sorry for these different questions.

    1. Thanks for the comment Mario. Let me take a quick stab at a couple of the Q’s, and I might have to circle back later when I have more time… basically, my first thought while reading your questions on my investments is to try not to overcomplicate it, and try not to categorize each investment. I have mentioned various categories, and various investors that have helped mold my investment style, but each individual investment decision stands on its own merit, and each one is slightly different. They are like snowflakes…

      Not that you have to agree with each investment you read here, but the basic idea is as you say–I happen to find a large gap between price and value in both of the stocks you mentioned. I find them to be simple businesses that I understand. Now, both are quite different… one I would categorize as a company that will likely grow intrinsic value over time, the other is a special situation. The latter-Barnes and Noble-is a situation where the corporate structure is undervaluing a core business that produces significant cash flow. In its simplest form, one could buy the company for $14, close the unprofitable business line, and be left with a core business (bookstores) that produces $4 of free cash flow. So I believe the bad business is masking a decent business that you can buy for around 4 times free cash flow. That to me is a big gap between price and value. A lot of people will cite the obvious headwinds that a brick and mortar store faces, and those are all obvious to me also, but those brick and mortar stores have some value, and I believe that value is more than 4x cash flow. So that in a nutshell is the logic. Very simple… of course, I could be wrong, and that is part of the game… but the logic is simple.

      So if you have to categorize it, I’d put it in some sort of Greenblatt special situation category, but I don’t really try to overcomplicate it that way. It’s just an undervalued business in my mind.

      The other investment you cited: Strayer… I bought it for the same general reason (I think there is a large discount to intrinsic value). One thing I’ll correct you on: the business produces extremely high ROIC. Strayer produces pretax returns on capital close to 100% (based on the last twelve months the ROIC is around 90%). If we capitalize the operating leases, the pretax returns still end up around 30%. This is a really high quality business based on those numbers. The main investment thesis here is you have a company that produces high returns on capital with a long history of stable free cash flow that trades at around 8 times FCF. It’s both cheap and good.

      A lot of thought went into these, but usually the investment thesis boils down to something very simple, such as my outlines above. Hope that helps…

      Just keep it simple, look for obvious situations that you can understand, and try to find businesses that will grow intrinsic value over time that produce stable free cash flow and high returns on capital that are available at cheap prices. Over time, that will likely do very well for you. There will always be other more nuanced opportunities that you can learn more about as your skills develop such as special situations, cheap/hidden assets, turnarounds, liquidations, restructurings, etc… but the simplest way to invest that provides you with the best opportunity to beat the market over time is to own good businesses at cheap prices. Time and probability will be on your side if you implement such a strategy with discipline and patience.

  4. Great thoughts, as always. I think an asset-based model has the flaw of having to be highly repeatable, i.e. you have to make a lot of correct decisions over and over. As soon as the market re-values an asset-based security that was undervalued, you need to sell–and find a new one. This creates a lot of re-investment risk, or in layman’s terms, you need a lot of good ideas. A company that has highly productive assets that create consistent cash flow will continue to deliver long into the future. A handful of these ideas at the right times only requires you swinging the bat a few times a year. In some ways, it is the difference between base-hits and home runs.

    1. You definitely need fewer opportunities with buying good profitable businesses with deep moats. In practice, it’s usually not the case that you need to buy more than 3-4 asset based investments over the course of a year, though. With net net stocks, for example, I typically don’t buy more than 4 a year. You can narrow the pool of investments down to the point where what’s left are the highest probability bets among securities of that type and you get the added benefit (with net net stocks, at any rate) of outperforming moast moat-type companies. Unlike a late Buffett style strategy, you don’t have to do deep qualitative research to find stocks that are likely to takeoff.

    2. Yes, I agree with those thoughts Matt. Although I tend to think of the company itself grinding out base hits (consistent FCF) year after year, which translates into an investment that continues to grow intrinsically over time.

  5. Hi John,

    I’ve recently discovered your blog and love it. It’s now ‘must reading’ along with “Oddball Stocks” and “OTC Adventures”.

    Mario asked to read your VIC submission, that makes at least two of us.

    1. Hi Jim,

      Thanks for the compliment and I appreciate you reading. I guess I forgot to address it in my long comment reply to Mario regarding the investments we discussed, but on VIC: I never did a writeup, and as of yet haven’t applied. So I don’t do writeups for them (at least not at this time). I am a member (i think he refers to it as a “guest” member), which anyone can become… it’s just that as a non-contributing member you don’t get access to the newest ideas (I think there is a 45 day delay, which never bothered me because I’m not really reading the site for ideas).

      Another benefit I’ve found as a guest member…. reviewing old case studies. I’ve talked about some of the other writeups available there, such as Charlie479. There are a few other good investors that post there and you can review their old ideas. If you are interested in what it takes to become a full member, you can review Greenblatt’s recommended writeups that he has on the site.

      At some point, I may apply there, and if I do, I’ll post my submission here (as long as I have permission to do that).

  6. great! past good earnings indicates high quality assets! but in today world earnings are very overrated! if the price is enough low,it is still worth to buy although past earnings may be not good!

  7. Graham’s “Interpretation of Financial Statements” is a good book, as you say, but it isn’t obscure by any means. I have a .pdf version, the one with an introduction by Michael Price (of Mutual Shares fame), which I obtained illegally on the internet. That text can be purchased through reputable book retailers.

    Please note that this text is, in a way, a companion to Security Analysis. Many of the quotes shown in John’s write-up above refer to themes which are expounded in Security Analysis itself.

    If you want a more modern text on financial statement analysis, take a look at Penman “Financial Statement Analysis and Security Valuation”. Penman seems to have a commitment to the value approach; indeed some of his early chapters contain passages which could have been written by Graham himself. However, Penman takes a few steps further, by trying to anchor modern valuation techniques on earnings projections which are derived from reformulated financial statements. Personally, I think Penman’s focus on forecasting is misplaced (as are some of his flirtations with CAPM), but the chapters dealing with financial statement analysis can be quite helpful.

  8. Yeah – I think Walter Schloss/Whitman was sort of the extension of Ben Graham. Obviously, as time went on and information became more widely available, net-nets disappeared. But Graham just liked net-nets because he could set a floor under what the company was actually worth, without speculating about biz prospects, etc. Schloss took this a bit further, and I think Marty Whitman does something similar, in that they’re all asset-based guys. But you cannot look at book value in a vacuum, and these guys don’t. It’s just a good place to start when trying to analyze replacement cost or private market value. And replacement cost/PMV are just other methods of setting a valuation floor. So, for example, Schloss would go out an buy a retail gasoline company when gas stations were getting hammered. We’re going to need gas for our cars for the forseeable future, so these assets aren’t going away, and in fact, over the cycle, they have to earn at least their cost of capital – supply will come out, and demand will increase, until returns on the remaining asset base surpass WACC. They basically took Graham’s “valuation floor” idea, and then set that floor by looking at the normal earnings power of a given asset base. PMV and replacement cost are related – if you can buy it for less than replacement cost, then you are buying it for less than PMV.

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