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Book Review And Excerpts: Benjamin Graham And The Power of Growth Stocks by Frederick K. Martin

Benjamin Graham And The Power of Growth Stocks is one of the most important investment books I’ve read. Employing the principles outlined in the book, the author’s firm (Disciplined Growth Investors) has generated exceptional results for its clients. One offers this summary in the book’s foreword:

When Frederick Martin “took over management of the (my firm’s) account in 1980, we had a total of $841,338 in the pension fund. Since then, some money has been added and some has been withdrawn, adding up to a total net addition to the original amount of $967,943. That means that, all in all, we have contributed a net total of about $1.8 million. Under Fred’s management, that sum had grown to $96.9 million as of April 30, 2011 – an increase of more than 5,000 percent.”
  • Craig R. Weflen, Administrator, Noran Neurological Clinic

Benjamin Graham of course wrote Security Analysis and The Intelligent Investor, two classics of investment literature. He was also Warren Buffet’s professor, employer and mentor for twenty years. Buffett worked for Graham’s  investment firm for two years starting at the age of 22. According to Wikipedia, Buffett felt that Graham’s approach to investing, while extremely valuable and logical, risked excluding companies that generated particularly high returns on capital and earnings growth.

As noted below, Graham gradually changed his view, and became more interested in growth stock investing, and less in value investing. Perhaps this was due to GEICO, a growth stock and Graham’s most successful investment, by far. GEICO yielded a greater return than all of the other investments he made in his career combined. And that’s despite having made thousands of trades in so-called “undervalued” stocks over a period of decades with good overall results.

In 1949, Graham’s investment firm put roughly a quarter of its assets into GEICO at $27 a share. It rose to the equivalent of $54,000 a share. Graham later wrote of the deal, which had been turned down by a number of other investment firms, “(it) almost fell through because the partners wanted assurance that the purchase price would be 100 percent%covered by asset value. A future $300 million or more in market gain turned on, say, $50,000 of accounting items.”

Two investment principles in the book that I find particularly fascinating and useful:

  1. Growth stocks tend to be more volatile than value stocks because their pricing reflects a prediction of future growth. When investors, in the aggregate, are optimistic, growth stocks trade at big premiums. When pessimistic, growth stocks often trade at values close to those of “value” stocks.
  2. Buying high-growth stocks of companies that offer something exceptional to their customers after a 30-50%percent decline from a market top has historically provided returns to investors way in excess of those of the overall market. Such an investment strategy requires doing battle with one’s own psyche – researching companies for years without investing, investing only every few years, holding for long periods of time, and buying during times of widespread negativity about the economy and the market.

Companies with an entrenched competitive advantage and above average growth generally trade at major premiums (30-500 percent) to the market’s average P/E ratio and price to book value. This premium for growth might be expected to exist four years out of five assuming that on average, the market goes up for three years, treads water for one, and declines 30 percent or more for one. During declines -- periods of widespread investor pessimism -- premiums for growth, for rosy predictions, diminish significantly.

The two investment principles espoused in the book that I do not incorporate into my own investment practices:

  1. Valuing a growth stock based on estimating earnings over the next seven to ten years is important to successful growth stock investing. (I don’t believe that most investors can reliably enough estimate future earnings or P/E ratios which are highly-dependent on future interest rates to be consistently useful).
  2. It is important to growth stock investing to purchase securities at a significant discount to the estimated present value of the future value as determined by estimated future earnings in order to insure a “margin of safety.” (I’m concerned that this rules out growth stocks with the best long-term prospects).

 My views aside, Graham offers the following formulas based on his study of the long-term relationships of growth to P/E ratio.

Page 54

What was Graham’s simple formula for calculating the intrinsic value of any public company? To calculate the intrinsic value, multiply the earnings growth rate by 2 and add 8.5 to the total, then multiply that by the current earnings per share. Here’s the formula:

         8.5 plus (2 x growth) x earnings per share = intrinsic value per share

 

Page 58

The revised Graham formula factors in the current yield to maturity on AAA corporate bonds in the calculation of a company’s intrinsic value:

To be used when current AAA bond rate exceeds 4.4. (March 2014 AAA bond rate = 4.42%).

         Intrinsic value per share = EPS x (8.5 + 2g) x 4.4/y

where y = current AAA bond rate

The book also offers:

  1. Important perspectives on how to identify companies that have sustainably high growth rates.
  2. Fascinating case studies of investments by the author’s firm, including those that worked out fabulously (Apple, for instance), were losers or mediocrities.
  3. The entire chapter “Newer Methods for Valuing Growth Stocks” from the 1962 edition of Security Analysis 1962 (a section unfortunately excluded from editions of Security Analysis after 2009). The chapter includes the simple mathematical formula Graham developed to value growth stocks, and a detailed analysis of appropriate P/E ratios for companies growing at various sustainable rates. I find the analysis fascinating, but do not accept the conclusions because I believe them to be too dependent upon future estimates of earnings and interest rates.

 Benjamin Graham And The Power of Growth Stocks offers this definition of value investing (on page 15): investing in mature companies growing more slowly than the average company. In other words, undervalued companies may actually be appropriately valued given that they are subpar at their purpose – creating wealth for their owners. As Graham states in a late edition of The Intelligent Investor, “The risk of paying too high a price for good quality stocks -- while a real one —- is not the chief hazard confronting the average buyer of securities . . . the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.”

 It is important to note that Benjamin Graham’s Security Analysis was first published in 1934, and was heavily influenced by investment losses incurred the 1929 collapse. This probably led to his strict adherence to the “margin of safety” principle – value a company and only invest when the value offered by the market is at a significant discount to that appraisal of value. The issue of course is: How do you value a company? Earnings and book value work well for broad market averages over long periods of time but are remarkably unreliable in individual securities. Copper mining companies are least expensive when their P/E ratio is highest.

Reaching an opinion of value of a business that is more reliable than the current market price is error-prone. I don’t believe that I can do it consistently. In my Wall Street analyst days, I would go to major trouble and expense to interview people in the know – current management (who is rarely candid on the subject of intrinsic value for a whole host of reasons), former management or directors, and current competitors. The values that that process generated were almost always different than the ones I came up with from financial statement and 10K analysis. Those with special knowledge of course were more accurate.

That aside, some of the particularly interesting perspectives offered in the book:

  • the purpose of a business is to create wealth; its value is related to its ability to do that. Valuable companies offer something unique and important to their customer by way of either product or price. The more unique, the more valuable to the customer and potential customer, the faster the growth rate and the greater the investment prospects of the company. (for an in depth study of this subject, see Michael Porter’s Competitive Advantage.)
  • discounts from liquidation value, or from ‘net, net’ asset value (cash and near cash assets minus all liabilities, per share), which Graham is particularly known for, rarely occur in companies that offer something unique to their customers

 The book offers these criteria in assessing the prospects for future profitability and growth:

(1) barriers that keep potential competitors out of the market, and (2) handcuffs on customers that make it difficult or costly to switch to another supplier.
(3) (those two from page 137 of the book, to which I would add – and admittedly closely related to (1) the presence or absence of technological change affecting either replacement or cost-of-production technologies.

 Also from page 137:

A sustainable competitive advantage is structural in nature, once it has been firmly established in the marketplace, it exists independent of future strategy choices. But strategy choices are still important because competitive advantage can clearly be enhanced or eroded by a successful or ill-advised strategy choice.
Predicting which companies will develop a future competitive advantage is far more difficult than identifying which companies currently have a competitive advantage.

 

The author offers two examples where he did just that – invested in companies with the potential to develop competitive advantages based on early signs that such an advantage was beginning to take shape -- McLeoldUSA, an investment that ultimately turned out to be a loser for his firm, and Apple. First, McLeod:

We utilized the Graham formula to determine the intrinsic value of McLeod. Although the company was generating positive operating cash flow at the time, it was not yet generating positive earnings per share because of heavy depreciation and amortization expense tied to its significant capital expenditures to build its nationwide network. We utilized a 20 percent normalized operating margin based on what we believed the company would achieve after its network build-out was completed and fully utilized. Applying the 20 percent operating margin to current normalized revenues of $1.4 billion resulted in normalized earnings per share of $0.57. We assumed that McLeod would grow normalized earnings by 18 percent. Applying these assumptions, the Graham formula looked like this:

[8.5 + (2 x 18%) x $0.57 = $25.37 intrinsic value.

Really? That seems so full of conjecture and assumption as to be meaningless. First, cash flow is irrelevant unless you know how much of the capital expenditure is needed to maintain current profitability. A 20 percent normalized operating margin may be valid and may not. Who knows? And 18 percent growth – that seems high without an established track record to go on. I don’t mean to suggest that the author’s principles are not valid, simply that it isn’t a science he’s employing. it is an art, and one subject to a wide variety of possible outcomes based on minor changes in assumption.

In the case of Apple, a highly successful investment for the author, he offers this review of the logic employed (page 194):

Because of the significant changes that were underway and the company’s recent return to profitability, it was particularly important to utilize “normalized” financial assumptions. We used normalized annual revenues of $5.8 billion after adjusting for product line eliminations. Although Apple’s turnaround had led to a dramatic acceleration in earnings, we felt it was prudent to use a normalized seven-year growth rate of 10 percent. A reasonable estimate of a normalized operating margin at the time was 10 percent, yielding normalized earnings per share of $0.52 on a split-adjusted basis.

Minor changes in projected revenues, operating margin and earnings growth would lead an analyst to widely-different estimates of value seven years hence. So wide, I submit, that the entire approach is suspect, unless one is a master in seeing the future. Obviously, based on results, the author is a master but I have substantially less faith in my own ability in this area. So little faith that I am unwilling to invest based on my own projections. Doubting my abilities is my “margin of safety.”

The author too offers skepticism about the predictions of others:

Page 24

We are continually amazed at the casualness with which Wall Street analysts forecast growth rates of 20 percent or higher. . . . Consider that a company that is growing at 20 percent will double in size every 3 1/2 years! . . . half the employees will have been with the company less than four years, and the customer base is likely to be relatively new. Internal budgeting is very challenging because the company will have to approximately double its physical space every 3.5 years. And adding to the challenge, fast-growing industries often attract tough new competitors.

 Page 60

 . . . one must adjust for where we are in the overall economic cycle and the company’s industry cycle . . . if the economy is in a recession, current earnings per share should be adjusted upward; in a boom period, they should be adjusted downward. If a company’s industry is in a recession or period of intense competition, current earnings per share should be adjusted upward. . . We encourage investors to base a growth rate on normalized earnings.

 Page 62

Over time, even the fastest growth companies mature, and their growth rate slows. In order to use Graham’s formula successfully, you need to slow the company’s growth at some future point. We have chosen to do this after seven years for each of our holdings.

The risk is that this process may exclude companies with an exceptional market position, competitive advantage and straight line forty percent growth. Conservative is fine, but as Graham says in Security Analysis 1962 edition:

We know, of course, that where high growth rates have been continued over long periods, investors have fared very well in such shares, even though they paid what seemed to be a very high multiplier of current earnings at the time. The outstanding example of such experiences is International Business Machines. Its apparent high selling prices in the past have always turned out to be low in the light of subsequent growth of earnings and subsequent price advances. The 1961 multiplier of, say, 80 times current earnings could also prove to be an undervaluation if the rate of past growth is maintained sufficiently long in the future. . .

A study by Cole Wilcox and Eric Crittenden of Blackstar Funds, LLC offers the following analysis of the Russell 3000 stocks between 1983 and 2006 (and reprinted at length in the book Trend Following by Michael Covel):

  • over the 23 year period, 39 percent of the stocks were unprofitable investments
  • 5 percent of stocks lost at least 75 percent of their value
  • a full 75 percent of all stocks returned zero to their investors over the 23 years
  • 494 stocks, or 16 percent of the total, returned 500 percent or more over the period

Any growth stock strategy that rules out IBM or Apple during their glory days might be more conservative, and reduce a portfolio’s volatility, but also has the potential to significantly lower long term results.

A different approach outlined in the book, and one more suitable to my own lack of talent as a prognosticator, is investing in high quality growth stocks after severe declines in the market averages. From page 101, Benjamin Graham And The Power of Growth Stocks

The stock market often reacts strongly to macroeconomic crisis. Many investors suspend their forecast of future progress for their companies. During these events, many investors believe that the future value of their stocks has declined. We think that those investors who sell during these times are making a predicable and catastrophic mistake. The future value of a company is more dependent on its management decisions and its industry conditions than it is on the general economy. But the massive press coverage of economic problems tends to override our sensibilities.

 

In the case of most major crises, the crisis occurs at the end of the problem – not the beginning. The crisis actually initiates the process of repairing whatever problem created the crisis.

In other words, while I doubt the usefulness of valuing growth stocks based on an estimate of future earnings growth, I firmly believe in the value of investing in growth stocks, in particular companies growing at rates in the top 10 percent of all companies, after severe market declines.

In closing, Benjamin Graham And The Power of Growth Stocks is an exceptional book written by someone who knows what he is talking about and has the track record to back it up.

As he writes on page 229 of the 283-page book:

There is no foolproof system for picking stocks. Even the most experienced money managers on Wall Street and the most powerful computers equipped with the most sophisticated stock-trading programs still get it wrong from time to time. And so do we. And so will you. There are no exceptions.

Finally, a couple of excerpts by Benjamin Graham. The first is from the last edition of The Intelligent Investor, the second from chapter 39 of Security Analysis (1962 Edition):

We know very well two partners who spent a good part of their lives handling their own and other people’s funds on Wall Street. Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world. They established a rather unique approach to security operations, which combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way they did quite well through many years of ups and downs in the general market; they averaged about 20 percent per annum on the several millions of capital that had accepted for management, and their clients were well pleased with the results.
In the year in which the first edition of this book appeared an opportunity was offered to the partners’ fund to purchase a half interest in a growing enterprise. For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.
In fact it did so well that the price of its shares advanced to 200 times or more the price paid for the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards. But since they regarded the company as a sort of “family business,” they continued to maintain a substantial ownership of the shares despite the spectacular price rise. A large number of participants in their funds did the same, and they became millionaires through their holding in this one enterprise, plus later-organized affiliates.
Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.
Veracity requires the admission that the deal almost fell through because the partners wanted assurance that the purchase price would be 100 percent covered by asset value. A future $300 million profit or more in market gain turned on, say, $50,000 of accounting items. By dumb luck they got what they insisted on.
 
The company referred to was GEICO, and the partners Benjamin Graham and Jerome Newman.

. . . . .

A study of actual investment results in groups of popular growth stocks will point up the need for substantial safety margin in calculating present values of such issues. We know, of course, that where high growth rates have been continued over long periods, investors have fared very well, even though they paid what seemed to be a very high multiplier of current earnings. The outstanding example of such experience is International Business Machines. Its apparent high selling prices in the past have always turned out to be low in the light of subsequent growth of earnings and subsequent price advances. The 1961 multiplier of, say, 80 times current earnings could also prove to be an undervaluation if the rate of past growth is maintained sufficiently long in the future. . . When growth-stock experience is viewed as a whole and not simply in the blinding light of IBM’s achievements, quite a different picture emerges . . .

 

Rod MacIver