He staggered and fell, grasped vainly at the stone, and slid into the abyss.
“Fly, you fools!” he cried, and was gone.
Four is The Bridge that connects Security Analysis’ Third (The Thinker) and Fifth (The Forecaster) editions. Published during a brief stock market decline during the market’s rise from 1949 to 1969, The Bridge resembles Mr Market’s ebullient mood in 2024.
Who cares about an investment philosophy penned 90 years ago?
By 1962, Graham’s transition from quintessential “value” was complete. Four was unique because it combined Graham’s voice and focused on growth.
Vulnerability was a theme of The Bridge.
Growth
Several editions define growth stocks as companies whose earnings increase from cycle to cycle. Four quantified that: a company with at least a 7.2% earnings CAGR is a growth stock.
Chapter 39 shares several methods for valuing them:
Molodovsky
8.6T + 2.1
Normalized earnings * (8.5 + 2G)
4th year earnings * multiplier (capped at 20x)
Assuming a growth rate of up to 10%, the earnings projections for each method are similar. When the growth assumption is above 10%, the earnings projections produced by different methods vary.
Molodovsky found the average common stock returned 7.5% (5% were dividends) between 1871 and 1959. His valuation assumptions were:
10th-year multiplier of 13.5x
Discount rate or required return of 7.5% per annum
Annual CAGR of 7.2%
An average payout of 60%
A growth rate assumption beyond 5% results in an infinite valuation with Molodovsky’s method.
As found in The Thinker, Charles Tatham projected the financials of a Public Utility in The Bridge. Despite that, Graham’s original message that trends are quantitative in form but qualitative in essence is emphasized in Four: the past is a fact, and the future is an assumption.
The Graham Gecko
The Bridge celebrated GEICO’s periodic stock dividend policy, in Chapter 36, as an example of a company issuing them per the earnings available.
The rebuttal against “value” investing is that Graham taught one philosophy but his highest-performing investment was from a “growth” stock.
“By 1972, at the Company’s then peak operating level, a single original Graham-Newman share of $27 had grown in worth to $16,349 - not quite the classic single cigar-puff, textbook Graham and Doddsville stock. Graham-Newman’s original 1948 investment of $712,000 was worth over $400,000,000 25 years later. Graham had scored a Peter Lynchian 500-bagger. Over the 40-year partnership, the gain in GEICO would come to represent a much larger percentage of the firm’s profits than its other investments combined.”
“Graham rarely allocated more than 5% of his investment portfolio to a single investment. Graham, “breaking badly”, so to speak, put nearly 25% of his partnership in GEICO. Thus, in 1948 Graham’s investment partnership purchased 50% of GEICO for $712,000. Graham’s one-half purchased interest amounted to a purchase of 1,500 shares at $475 per share (a 10% discount to book value).”1
Syllogism:
noun
noun: syllogism; plural noun: syllogisms
an instance of a form of reasoning in which a conclusion is drawn from two given or assumed propositions (premises); a common or middle term is present in the two premises but not in the conclusion, which may be invalid (e.g. all dogs are animals; all animals have four legs; therefore all dogs have four legs ).
Premise I: Graham, a value investor, bought GEICO, a growth stock.
Premise II: GEICO was Graham’s highest-performing idea.
Conclusion: Graham taught “value” investing but benefitted most from “growth”.
Notice the last line of the quote above. Graham purchased GEICO at a 10% discount to book value. An insurance company trading below Book Value is cheap. Look how Walter Schloss remembered Graham’s investment:
“Q: you were going to tell us a story?
A: I was in Graham’s office the day he first bought Government Employees Insurance Co., which is GEICO. Warren owns one-third of the stock today.”
Q: His famous coup.
A: That’s right. But the funny part is that I was in Graham’s office when a phone call came from the lawyer, who said, “You bought your 50% of the company” – and Graham paid something like $750,000 for 50%, or something on that order. Anyway, he turned to me and said, “Walter, if this doesn’t work out, we can always liquidate it and get our money back.” He had no conception of the growth potential of this thing. He was just buying an insurance company cheap.
Q: He was worried about what he could lose?
A: Yes. Graham liked the idea of protection on the downside, and basically, that’s what I do. I try not to lose money.”2
GEICO was purchased as a value investment and was also a growth stock. This is nothing new, though: value is a function of growth. As a talented historian is wont to do, Graham unified the essences of two ideas typically framed as opposites (i.e. growth vs value) and transcended the debate.
Riskless Reward?
In Four, the authors argued that the equity risk premium concept is redundant. It implies that bond interest rates accurately measure risk even though the risk is not distributed evenly but in an immeasurable and impossible-to-predict way.
Harry Markowitz published his postgraduate thesis Portfolio Selection (1952) in The Journal of Finance. His ideas laid the foundation for the capital asset pricing model and modern portfolio theory. Markowitz wanted to optimize a portfolio’s expected return for the lowest amount of volatility. As such, one could justify adding “risky” securities if they diversified the portfolio and made it more stable.
Markowitz and Graham diverged in their definitions of risk: Graham defined risk as a permanent capital loss but Markowitz defined risk as the variance in expected returns. Graham defended against risk whereas Markowitz managed it.
Graham’s net net strategy epitomized that approach to risk: find financial fortresses that can weather almost any storm. Is a net net owning only cash and no operating business an actionable investment?
“A company with nothing but cash in the bank could not possibly earn enough to support a market price equal to its cash-asset value.”
LGL Group, owned by the Gabelli family, divested its various concerns over 20 years until LGL only had minority interests in two subsidiaries. In Winter 2022, $LGL sold at $4 per share vs its c. $7 cash per share. During Spring 2024, it is priced at $5.70 per share.
In The Bridge, the authors compared F.H. Shattuck and B/G Foods. Shattuck had “idle cash” whilst B/G Foods had more sales per equity. Shattuck had $7.7 per share in free cash and tangible assets of over $10 per share. It sold at $5 before speculative interest arrived and the share price spiked.
“unless they are in a kind of business that may produce large operating losses they can hardly fail to work out satisfactorily on a group basis.”
A security – regardless of its form – is safe if the enterprise can meet its obligations (now and in the future). In most cases, that has more to do with the earnings than the asset value.
However, in some cases, assets are more important than earnings:
Railroad Equipment Certificates
Investment Company Bonds
Public Utilities
Four introduces the Factor of Safety Test in the main text whereas One and Two are only referenced in their footnotes. It was left out of Three, Six, and Seven.
The Factor of Safety Test is like an operating margin for bondholders. It is the operating income minus fixed charges plus taxes as a percentage of operating revenue.
Why did The Bridge explicitly discuss this Test when others didn’t?
The other two tests — interest coverage and income-debt ratio — for bond safety could be passed by a railroad with a high operating ratio and low fixed charges as a percentage of operating revenue and still be vulnerable to shrinking revenue or increasing expenses. This bondlike operating margin offered another way to judge a road’s margin of safety.
On Equities
In Chapter 18, the authors studied the exhibits of two chemical companies (Union Carbide vs Koppers). Koppers had more tangible assets and paid a higher dividend. Union Carbide had more sales, an earnings margin three times as large, slightly better interest coverage, a lower largest decline in return on total capital, and more leverage. The product mix of Union Carbide was 75% in chemicals and plastics (the highest margin segment) vs Koppers’ 25% of sales.
Conclusion: earnings drive share prices. In this case, the higher-quality company (Union Carbide) outperformed its cheaper competitor.
In Chapter 19, the authors presented the changes in maintenance expenditure as a ratio of operating revenue for 8 roads and the income account for Chicago, Rock Island & Pacific R.R. and Atchison, Topeka, & Santa Fe R.R. vs the aggregate of all class I roads.
The same chapter comparatively analyzed 8 chemical companies also. The authors discussed price-to-earnings ratios, earnings margins, capital turnover, and earnings on total capital.
American Cyanamid had the third-highest increase in earnings compared to the previous period of 1947-1951 but sold at a lower p/e ratio than the chemicals market. This might be because it had almost the lowest return on total capital over the previous three decades. In the same period, Cyanamid was the only company to increase its earnings margin. That was achieved with a stable capital turnover whilst every other chemical company increased their turnover.
Amortization Adventures
Post-WWII depreciation charges were no longer applicable to economic reality as strong inflation increased the replacement cost of physical assets. A few years before The Bridge’s publication, Wall Street began to emphasize earnings before depreciation.
Four distinguished gross “cash flow” from net cash flow. For modern readers, the former is EBITDA and the latter is cash flow from operations minus capex.
The 10-year performance of Sinclair Oil exemplified that gross “cash flow” does not represent true earnings. If — as runs Wall Street’s reasoning — earnings before depreciation were the true earnings then several years of amortization charges — considered reinvested profits — would result in more equity and net income.
In practice, the cash income for Sinclair Oil between 1950 and 1960 was c. $1.5bn. Its total amortization charge over that period was $800mm but shareholders’ equity increased only by $415mm. During the decade, net income declined. If the amortization charges of $800mm represented reinvested profits, why did the reinvestments result in lower earnings?
“The transfer of emphasis from the net earnings to the cash flow is not warranted by the underlying facts or by logic; that it has been inspired largely by the high price-earnings ratios created by the great stock market advance”
In 1960, American Consumer Products acquired two ice companies below their net current asset value and implemented a negative amortization charge. You can think of this as a de-depreciation or appreciation charge.
David Rolfe, ‘GEICO: The “Growth Company” that made the “Value Investing” careers of both Benjamin Graham and Warren Buffett’ (2016).
Who is Walter Schloss and Why is he Such a Great Investor? Barron’s 1985, February 25.