Graham today
Graham's postscript on one lucky, well-prepared decision, Zweig's closing advice, and a review of the whole path.
FinanceGraham postscriptAbout 7 min: 4 reading, 3 practiceUpdated
General education, not financial advice.
- Retell Graham's postscript story and the morals he drew from it
- Sort Graham's ideas into those that hold up and those that have dated
- Review the path's main ideas before the self-test
The Intelligent Investor: Benjamin Graham's ideas: lesson 24 of 24
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Graham ch. 10
- The investor and his advisers 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), Postscript and its commentary
What it is
Graham's postscript. Graham tells of "two partners" (Zweig explains they were Graham and Jerome Newman) who managed money cautiously for many years, with a portfolio of more than a hundred holdings, and averaged about 20% a year. Around 1948 they bought a half-interest in a growing business that Wall Street had turned down, because the price was moderate against its earnings and assets. It cost about a fifth of their fund. (Zweig identifies the company as GEICO, the insurer.)
The shares rose to two hundred times or more the price paid, far beyond what the partners' own standards would justify, but they kept a large holding. That one decision made more profit than all their other operations over 20 years.
Graham's morals:
- There are several different ways to make and keep money on Wall Street.
- One lucky break, or one supremely shrewd decision, may count for more than a lifetime of ordinary work, and Graham asks whether we can tell the two apart.
- Behind it there must usually be preparation and disciplined capacity: being known enough for such chances to arrive, and having the means, judgement and courage to take them.
Quick check
Tap an answer to check it.
What made the partners willing to buy the half-interest, according to Graham?
- Several important houses had turned it down
- The rise came later and went far beyond their standards
Show answer
The price was moderate in relation to current earnings and asset value. The decisive factor was the price against earnings and assets.
Why it matters
Zweig's closing commentary. Putting a quarter of a fund into one stock looks like a gamble, Zweig writes, but Graham had established that he could liquidate the company for at least what he paid, so the financial risk was small; the courage was psychological. He adds a warning for the rest of us: since Graham himself called GEICO a lucky break, most investors cannot count on finding such a chance, and should diversify. Uncertainty, he says, is the permanent condition of investing, and investing takes a belief in a better future.
What holds up from the path:
- Investing versus speculation: thorough analysis, safety of principal, an adequate return.
- Mr. Market: prices are there to use, not to obey.
- The margin of safety, and diversification alongside it.
- The defensive investor's simple, mechanical plan, now often met by a low-cost index fund (Zweig).
- Elementary checks first: coverage, debt, earnings records, price against value.
What has dated:
- The figures: 1972 dollar limits, bond yields, P/E levels and the companies themselves.
- Some instruments: warrants are now rare; convertibles have changed.
- Some parts Graham pared back himself: Zweig notes he cut his discussion of shareholders and management from about 34 pages to under eight, evidently doubting investors would use it.
The method, not the 1972 numbers, is what the path has tried to teach.
Worked example
A review in one company. A made-up firm: price 30, average earnings per share over three years 2.40, book value per share 24, current assets 500, current liabilities 200, long-term debt 250, and good bonds yield 5%.
- P/E: 30 ÷ 2.40 = 12.5. Within Graham's defensive limit of 15.
- Price / book: 30 ÷ 24 = 1.25. Within 1.5; and 12.5 × 1.25 ≈ 15.6, within 22.5.
- Financial strength: current ratio 500 ÷ 200 = 2.5; working capital 300 is above the debt of 250.
- Earnings yield vs bonds: 2.40 ÷ 30 = 8%, 3 points above the 5% bond yield: a margin of about 30% of the price over ten years, less than Graham's earlier typical 50%.
On these figures it passes the price and strength tests, but the earnings-yield margin is thinner than Graham liked. The remaining tests (ten years of earnings, twenty of dividends, growth) need the company's history.
Common mistake
Taking the GEICO story as permission to concentrate everything in one idea. Graham himself does not know whether it was luck or shrewdness, and Zweig draws the opposite lesson for most investors: diversify.
Key terms
- postscript
- Graham's closing story about one decisive investment
- preparation
- the knowledge, standing and means that let a person act on an opportunity
- concentration
- putting a large share of money into one holding
- earnings yield
- earnings per share ÷ price
Practise the key terms
Tap a card to turn it over. 4 cards.
| Front | Back |
|---|---|
| postscript | Graham's closing story about one decisive investment |
| preparation | the knowledge, standing and means that let a person act on an opportunity |
| concentration | putting a large share of money into one holding |
| earnings yield | earnings per share ÷ price |
Practice
Work it through
Price 28; average EPS of the last three years 2; book value per share 20; good bonds yield 4%.
- 28 ÷ 2
- 28 ÷ 20
- 2 ÷ 28 × 100
- 7.14 − 4
Sort it
Which group does this belong to?
Buy with a margin of safety
The central idea of the bookShow answer
Holds up. The central idea of the book
A 100 million dollar sales minimum for "adequate size"
A 1972 figure that needs updating for inflationShow answer
Has dated. A 1972 figure that needs updating for inflation
Treat market prices as offers you may accept or ignore
Mr. MarketShow answer
Holds up. Mr. Market
Studying stock-option warrants as a common instrument
Warrants are now rare among major companiesShow answer
Has dated. Warrants are now rare among major companies
Check interest coverage and debt before anything else
The lesson of the four case historiesShow answer
Holds up. The lesson of the four case histories
Quick quiz
Tap an answer to check it.
What moral did Graham draw from the GEICO story?
- Zweig draws the opposite lesson for most investors: diversify
Show answer
One decision, lucky or shrewd, can outweigh a lifetime of ordinary work, but it usually rests on preparation. Graham asks whether luck and shrewdness can even be told apart.
Why does Zweig say Graham's GEICO purchase carried little financial risk?
- Zweig notes GEICO later came close to bankruptcy
Show answer
Graham had established he could liquidate the company for at least what he paid. The margin of safety was in the company's realisable value.
In the worked example, why is the margin thinner than Graham liked?
- It is 12.5, within his limit
Show answer
The earnings yield is only 3 points above the bond yield, about 30% over ten years against his earlier 50%. The price and strength tests pass, but the earnings margin over bonds is small.
In short
- Graham's postscript: one well-prepared decision (GEICO) outweighed 20 years of careful work; luck and shrewdness are hard to tell apart.
- Zweig: Graham's risk was small because of the asset value behind the price; most of us should diversify.
- What holds up: investment versus speculation, Mr. Market, the margin of safety, simple defensive plans, elementary checks.
- What has dated: the 1972 figures, some instruments, some of Graham's own views.
Mastery check
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Check yourself
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About what share of their fund did the partners put into the half-interest?
Show answer
About a fifth (Zweig says roughly 25%).
A share sells at 40 with average earnings of 2.50. Does it pass Graham's defensive P/E test?
Show answer
No: 40 ÷ 2.50 = 16, above 15.
Which lesson does Zweig draw from the GEICO story for most investors?
Show answer
Diversify, because few can count on finding such a chance.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), Postscript.
- On this site: Investment versus speculation, Mr. Market and Margin of safety (1): the idea.
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