Memo to Ben Graham: Help!

Globe Investor Magazine, November 18, 2008
Photograph by Spencer Platt/Getty Images

In 1933,his investments jumped back up by half, and by 1935, he was almost back to where he had been before the Great Crash. Along with buying bargain stocks, Graham dabbled in areas like breaking up undervalued companies and snapping up distressed junk bonds. It wasn't a single home run but a long slog, and from the Depression until 1956, when he ended his investment partnership, Graham's picks grew by a healthy 17% a year. By beating that early brush with bankruptcy, he went on to become a millionaire.

So what might Graham have surmised about the global financial meltdown of 2008? "He might say that the markets were overvalued before, and now they've probably overreacted to the downside," says UWO's Athanassakos. In fact, since Graham's goal was to find stocks valued at a 50% discount to their assets-in modern times, a near-impossible standard -this is probably the closest we've been to Graham-esque values in a long while.

As such, there are bargains cropping up that might have appealed to the master: companies with a P/E below 12, say, with a price-to-book value ratio below 1.5, with strong cash flow and little debt.Yale University professor Robert Shiller-of the famed Case-Shiller U.S. housing price index, which has been so ravaged-keeps tabs on what he terms the Graham P/E,which divides stock prices byearnings averaged over 10 years. That number is now 15, the lowest it's been in almost 20 years.

"Now is a time when Graham would be looking to buy from Mr. Market," says Wall Street Journal scribe Jason Zweig, author of Your Money and Your Brain. Zweig's column "The Intelligent Investor" is named after Graham's investing bible. "Price/ earnings ratios have fallen below historical norms. Dividend yields are the highest they have been in many years, and twice the yield on Treasurys. Hundreds of companies are trading for less than the total value of the cash on their balance sheets; many dozens more are also trading for less than their net current assets. Mr. Market has not had a selling panic on this scale since the early 1970s." It's those kinds of valuations that are keeping Kyle Holmes up at night with anticipation. Holmes, another diehard Graham aficionado and a student at the University of Saskatchewan, is seeing more and more companies come onto his investing radar. From the wreckage of the meltdown of 2008, he hopes to add to a portfolio that already includes Warren Buffett's Berkshire Hathaway.

"I've been actively watching about a half-dozen companies, and hopefully will be making a move soon," says the 22-yearold. "I feel that with the huge headwinds we're facing, the forced selling of hedge funds and mutual-fund redemptions, the wealth effects and the margin calls will all make the companies I'm currently watching even better buys. But it is very tough to keep an even keel right now."

Case in point: the financial sector, which is so off-balance that it doesn't even seem to have a keel. Transported to 2008, would Ben Graham have invested in any of the seemingly cheap financials, which turned into spectacular stock flameouts? Likely not, says the Journal's Zweig. That's because Graham's key credo was that "an investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

In Zweig's view, thorough analysis of banks or insurers right now is almost impossible, since the institutions themselves don't know the value of the toxic assets they're holding. Dodgy sub prime mortgages have been sliced and diced into so many securities that it's a fool's errand even for professional investors to try to put a price tag on them.

If a company's numbers are a black box of impenetrability, then the correct move-and what Graham would have done- is to simply back off. The good news is that Canadian value managers, for the most part, have stayed true to Graham's principles and eschewed American financials for that very reason. "They've shied away because of the complexity of their balance sheets," says Morningstar's Benincasa."Atypical deep-value manager, following the Graham-Dodd approach, is biased against the American financials right now because it's so difficult to ascertain their liabilities."

So far, so good. Unfortunately, though, many value managers are handcuffed now that the market has fallen so low. While the TSE and the Dow have slid south, managers have largely used up the excess cash they had built up, and are close to fully invested. That, along with the fact that some panicked investors are throwing up their hands and taking big redemptions from their funds, hampers managers' ability to take full advantage and keep buying at rock bottom.

And so, value investors wait and worry, as Mr. Marketwipes away trillions in wealth. If it's any comfort, investors can be assured that Ben Graham himself went through the very same soul-searching that is wracking everyone else. The multiple plunges of the Dirty Thirties rattled Graham to the core."We cannot fail to be struck by the increasing tendency towards instability even in relatively normal times," he wrote. It would be "imprudent to minimize the significance of what has happened and to return over readily to the comfortable conviction of 1925 that we were moving steadily towards both greater stability and greater prosperity."

If the father of value investing was spooked enough to call for caution and a flexible market strategy, then you should tread carefully, too. But as long as you have an iron stomach for risk, "I think he would probably be buying all the way down," says Morningstar's Benincasa. "I'd suggest for investors right now to keep their money in, and maybe add even more. There have been deep downturns in the past,but over the long term, value investing is a phenomenal strategy."

Face value

There are two centres in the world dedicated to the study of ben Graham's groundbreaking investing philosophy. one is at columbia university in new york city, where Graham himself used to teach. the other is at the richard ivey school of business at the university of western ontario. we talked to the director of uwo's ben Graham centre for Value investing, Professor George Athanassakos, about what readers should do with their money when the world is on fire.

How should investors ride out this storm?
They shouldn't panic. i don't think there's going to be anything like the Great depression. Go back in history, and every 20 years or so, there's a financial panic. ben Graham himself almost went bankrupt because of the 1929 crash. but then he applied his own principles, and became a millionaire.

How do you determine intrinsic value, when balance sheets seem to be morphing all the time?
With the financials, no one really knows what they're hiding. some of them have fallen so much that it makes one tempted to invest, but be very careful. you should only invest in financials with solid, conservative management. the market has lumped in the good with the bad, and you have to figure out which is which.

What metrics can help guide us through this storm?
You start with metrics like P/e and price-to-book. those are signals stocks may possibly be undervalued, but then you have to take a second step and actually value the companies. you also have to build in a margin of safety, so that even if you think a stock is worth 10, you don't buy until it falls at least a third below that, to 7.

What sectors might Ben Graham find attractive right now?
Possibly pharmaceuticals, because they haven't done much for 10years now, and are paying huge dividends. if you buy Pfizer and it just sits there, you'll still make 7% a year. i'm also tempted to look at housing, because it's been beaten down very badly, and at branded consumer stocks like Procter & Gamble and colgate-Palmolive.