Benjamin Graham and David Dodd were among the first investors to make the transition from thinking like traders to thinking like owners. In the shadow of the 1929 stock market crash, they posed a set of questions that are still applicable today: What would a reasonable businessperson, as opposed to a speculator, pay for a company and still considerthat he or she was getting a bargain? What entry price would almost guarantee at least an eventual return of capital with good prospect for gains? Could a prudent investor reasonably allow for a margin of safety in his or her purchase?

Although the questions have remained the same, the ways to answer them have changed. A Modern Approach to Graham and Dodd Investing examines the classic Graham and Dodd approach to valuation and updates it for the twenty-first century. Thomas Au, a portfolio manager with a leading insurance company and ex-Value Line analyst, reworks the basics of value investing from net present value, financial statement analysis, and return on capital to return and leverage, asset allocation, and diversification.

Before learning about the modifications to Graham and Dodd’s principles of value investing, you’ll be introduced to some basic investment concepts and mathematical measures forthe calculation of investment returns. From there―although the focus of the book is on stocks―you’ll first become familiar with bonds, because an understanding of the risk and return characteristics for bonds underpins an understanding of those for equities.

Recent examples, including Enron and WorldCom, are introduced throughout these pages, to illustrate exactly how you can use this updated approach to your advantage. Topics ­explored in this comprehensive book, include:

Part I: Basic Concepts

Part II: Fixed Income Evaluation―bills, notes, bonds

Part III: Equity Evaluation―cash flows, capital expenditures, asset value, dividends, ­earnings

Part IV: Special Vehicles for Investment―mutual funds, international investing, real estate

Part V: Portfolio Management―asset allocation, modern theories vs. Graham and Dodd

Part VI: Some Contemporary Issues―the Dow, excessive credit creation, generational ­cycles in the American stock market

A Modem Approach to Graham and Dodd Investing examines the changes that have taken place in the financial world since the days of Graham and Dodd, and reveals the necessary modifications you must make in order to apply these value investing principles in today’s markets. Filled with in-depth insight and practical advice, this valuable resource offers an updated form of Graham and Dodd that will help you face today’s market realities.

THOMAS P. AU is a Vice President and Portfolio Manager for the investment arm of a large insurance and healthcare provider. His specialty is emerging and international markets. He has also worked for Unifund, an emerging markets firm in Geneva, Switzerland. Previously, he was an analyst for Value Line, an investment information company in New York City, serving in various capacities from 1983 to 1994. Mr. Au has received his BA, cum laude, with a double major in economics and history, from Yale University, and an MBA in finance from New York University.

A Modern Approach to Graham and Dodd Investing

By Thomas P. Au

John Wiley & Sons, Inc.

Copyright © 2004 Thomas P. Au
All right reserved.
ISBN: 978-0-471-58415-5

Chapter One

Introduction

October 1929 marked a watershed of investing in the United States. Following a nearly decade-long bull market, the Dow reached a peak of 381.17. It then began a long and sharp decline, plunging to a sickening 41.22 in 1932, ruining many investors. Finally, the Dow recovered to the low 200s, which represented a "normal" level for the time. Serious investors wondered if these were random moves. Or could an intelligent investor determine "reasonable" levels for stock market prices and profit from this knowledge?

In 1934, a pair of investors, Benjamin Graham and David Dodd, began to make sense out of the wreckage. The problem during the late 1920s was that easy money, easy credit, and the resulting go-go era had turned the stock market from an investment vehicle into one of speculation. (This happened again in the mid-1960s and again in the late 1990s.) Stock prices had become divorced, in most cases, from the underlying value of the companies they represented. It took corrections of exceptional violence in the early 1930s, the early 1970s, and, by our reckoning, to come in the mid-2000s, to restore the link between stock prices and underlying values. In retrospect, one could, by careful analysis, find a reasonable basis for stock evaluations even in the Depression environment of the 1930s.

Graham and Dodd were among the first investors to make the transition from thinking like traders to thinking like owners. In the crucible of the Crash, they posed a set of questions that are still applicable today: What would a reasonable businessman, as opposed to a speculator, pay for a company and still consider that he was getting a bargain? What entry price would almost guarantee at least an eventual return of capital with good prospect for gains? Could a prudent investor reasonably allow for a margin of safety in his purchases?

If one believed the intrinsic value of a business was estimated to be worth $100, and the stock was selling at $95, it was no bargain. An estimate of the business value is just that-an estimate. The business might well be worth only $90. However, if the stock were selling at $50, it was clearly a bargain. A reasonable businessperson's valuation of a company might easily be off by as much as 5 to 10 percent. It would not likely be off by 50 percent. The difference between a price of $50 and an estimated value of $100 allows for a large margin of safety.

There are two types of risk in the stock market: price risk and quality risk. Price risk signifies the tendency to overpay for the stock of a perfectly good company. Quality risk involves buying the stock of a company that will never prosper, or worse, go into bankruptcy, possibly costing the shareholders their entire investment. Although the latter type of risk is more dramatic, because of its higher stakes, the former is more common, and hence more costly in the long run. Only a handful of companies actually default, and many of the ones that do experience financial difficulties make out all right in reorganization. Price risk routinely affects nearly all companies from time to time, particularly good companies, for which investors have overly high hopes. If you buy at the top and there is a subsequent decline, you could lose 30 to 50 percent on your investment in short order. That is why price risk is considered the greater danger, even though default risk is a serious matter. If debt holders get less than 100 cents on the dollar, shareholders may end up getting nothing (although in practice, shareholders rarely lose everything in a bankruptcy, because a few crumbs are usually thrown their way to ensure cooperation in a restructuring).

However, Graham and Dodd felt that even default candidates were likely to produce profits if they were purchased at a sufficiently low price and enough of them were owned to allow the law of large numbers to work in their favor. Indeed, these investors managed a bankruptcy/liquidation fund that did somewhat less well than the regular fund on a nominal basis, and much less well than conventional investments, after adjusting for risk.

Classic Graham and Dodd investing involves buying the stocks of average- to above-average-quality companies at a low price. If a stock is trading at the low end of its historical valuation band, the downside risk is lower than it would otherwise be, and the upside potential is at its maximum. This book will discuss some of the diagnostic tools used by Graham and Dodd to determine value, and then present updated versions used by modern practitioners.

GRAHAM AND DODD CRITERIA FOR SECURITIES SELECTION

Graham and Dodd proposed stringent criteria for their investments, and because of the generally depressed valuations, found many securities that met these criteria in the 1930s.

The first of these requirements was for the stock to sell below its stated per-share net asset value or book value. Provided that book value was a minimum estimate for asset value (as verified by other tests listed below), an investor who purchased a stock below book value would be getting assets worth more than the investment.

It would be much better if the company could also meet certain liquidity tests. Graham and Dodd found a number of companies whose market value (stock price multiplied by the number of outstanding shares) was less than the company's liquid assets, such as cash, accounts receivable, and inventory, minus accounts payable and short-term debt, or what we would now call working capital. In an even better situation, working capital would be greater than the market value of stock plus long-term debt, or what we would now call enterprise value. An investor who bought the stock of such a company would effectively be paying less than nothing for the business as a going concern. Given the Depression nature of the time, this was not an unreasonable requirement.

Moreover, the company had to be profitable. The growth rate of profits, on which most modern analysts base their decisions, was much less important because, during the Depression, profits often fell. But some profitability ensured that assets, at least, would grow. So the company was expected to be an all-weather earner, able to generate profits even in tough times, not just a fair weather operator.

Nearly as important was the question of dividends. Provided that they were covered by earnings, the periodic payouts would guarantee a return, while the assets underpinning the principal would increase. If there were earnings, but the dividends exceeded them, then the distributions would be more in the form of a payback of invested capital, rather than that of a return. But at least the investor could be confident of getting back the original investment, plus a little more.

Graham and Dodd asked for a dividend yield (dividend divided by the stock price) of at least two thirds of the AAA bond yield. This requirement ensured that the stock had to be competitive with bonds as an income-producing instrument-a sensible criterion. Since bonds are inherently safer than stocks, one would have to have a reasonable assurance that the total return, dividends plus capital gains, eventually would be greater than bond returns. If there were dividend growth, a dividend yield that started at two thirds of the bond yield would eventually exceed the fixed income stream,...