Ben Graham on intellectual honesty and financial landmines

Ben Graham on intellectual honesty, financial landmines and tottering giants

The financial deluge

From social media to get-rich-quick books, there is a deluge of professional opinion for people who want to be told what to do and what to think. As Ben Graham reflects in The Intelligent Investor, this is actually quite peculiar. By asking experts what stocks to buy and sell, people are essentially asking them how to make money.

To Graham, this “idea has some element of naïveté”. The expectation that there are shortcuts to riches, and that we can buy such information, has “no true counterpart in ordinary business affairs”. Small businesses, for example, seek help on aspects of their operations. But they do not ask people how to make money.

“Nearly everyone interested in common stocks wants to be told by someone else what he thinks the market is going to do. The demand being there, it must be supplied.”
Ben Graham. (1973). The Intelligent Investor.

Misalignment, noise, and tomfoolery

Born from such desire is an advisory ecosystem, filled to the brim with colorful theories, models, and products, each more sophisticated and authoritative than the last. And as Nassim Taleb observes in Skin of the Game, there are strong incentives for advisors, salespersons, and some experts (intentional or not) to maintain this veneer of complexity. To justify their fees, we’re led to believe that such wizardry is the purview of the chosen few.

That’s not to say that the industry does not play an important information function. But some shrewdness in regard to advice is welcome given the amount of misinformation, noise, and tomfoolery that takes place in the market.¹

“The inquirer always thinks he has good reason for assuming that the person consulted has superior knowledge or experience. Our own observation indicates that it is almost as difficult to select satisfactory lay advisers as it is to select the proper securities unaided. Much bad advice is given free.” Ben Graham. (1973). The Intelligent Investor.

[1] Perhaps there is some irony in Graham’s words, given his book sells for roughly twenty bucks today; And that I am sharing a part of his wisdom here with you here. That is, you would be wise to treat everything we say here with plenty of skepticism, too.

The paradox of mathematising finance

In science, we use mathematics to describe and understand our world. But “in the stock market, the more elaborate and abstruse the mathematics, the more uncertain and speculative are the conclusions we draw therefrom”, Graham writes. Math in finance, he says, is a “special paradox”.

As Mervyn King and John Kay note in Radical Uncertainty, it is important to distinguish between what is risk and uncertainty, and what is knowable and unknowable. People are quick to draw a false sense of security from fancy projections and black box models.

“Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment. … We must point out a troublesome paradox here, which is that the mathematical valuations have become most prevalent precisely in those areas where one might consider them least reliable. For the more dependent the valuation becomes on anticipations of the future… the more vulnerable it becomes to possible miscalculation and serious error.”
Ben Graham. (1973). The Intelligent Investor.

As Jason Zweig observes, “Graham announces from the start that [his] book will not tell you how to beat the market. No truthful book can”. Alarms should chime, Zweig says, when you hear phrases like “guaranteed”, “no downside”, and “a sure thing”. Intellectual honesty is paramount.

Financial landmines and booby traps

Where junk advisers make up one evil, accounting shenanigans throttle the other. On the topic of earnings, Graham proffers two reminders. One, “don’t take a single year’s earnings seriously”. Two, “look out for booby traps in the per-share figures”.

Unscrupulous managers will resort to trickery when the opportunity beckons. Their accountants might tinker with special charges for recurring expenses, convenient schedules for depreciation, or adjust recording rules for revenues and inventory.

Graham recalls, for example, how companies, in an attempt to stabilize reported earnings, introduced “contingency reserves” to move profits from good years to the bad. Today, the opposite is more popular, as managers try to stave off bad news.

While accounting is the language of business, it is not always representative of economic reality. Like bad advisers, such mischief and fraud deserves special attention. (For more on this topic, I recommend the book Financial Shenanigans.)

Four telltale cases

Sales bravado, nonsensical math, and accounting wizardry can account for many disasters in common stocks. Graham and Zweig highlight four ways in which they frequently manifest themselves: (1) empire builders; (2) tottering giants; (3) worthless issues; and (4) bloated minnows.

Empire builders

The first is the “empire building” conglomerate. Companies like Ling-Temco-Vought, Graham notes, is a “story of head-over-heels expansion and head-over-heels debt” that culminates eventually in “terrific losses” or collapse. Zweig provides another case with Tyco, whose acquisition strategy produced stellar paper results in the early 2000s, not long before impairments and fraud tanked the company.

Tottering giants

Then there is the “tottering giant” with a high share price and an awful balance sheet, of which the market happily ignores. Graham recalls, for example, the bankruptcy of Penn Central Railroad in 1970. Despite being the largest railroad (both in assets and revenues) in the United States, they were unable to meet their obligations in a liquidity crisis. Instead, they achieved the largest bankruptcy in U.S. history at the time.

Zweig points similarly to Lucent Technologies, which was the twelfth most valuable company (by market capitalization) in the United States during the dotcom bubble. This was despite their questionable decisions, like paying for $4.5 billion for Chromatis Networks — a company with no revenue or customers, around 150 employees, and very few tangible assets. By the dotcom’s end, Lucent’s stock fell from $51 in 2000 to less than $1.3 in 2002.

Worthless issues

Worthless companies tend to file for public offerings when the bull market is raging. Graham recalls AAA Enterprises, which derived much of its attention from the market’s obsession for “the magic word ‘franchising’, and little else”. The company filed for bankruptcy “within two years of the stock sale and the doubling of the initial inflated price”.

As Graham reminds:

“When the going is good and new issues are readily salable, stock offerings of no quality at all make their appearance. They quickly find buyers; their prices are often bid up enthusiastically… Wall Street takes this madness in its stride, with no overt efforts by anyone to call a halt before the inevitable collapse in prices. … When many of these minuscule but grossly inflated enterprises disappear from view, … it is all taken philosophically enough as “part of the game.” Everybody swears off such inexcusable extravagances — until next time.”
Ben Graham. (1973). The Intelligent Investor.

Bloated minnows

Finally, there are occasions when, as Zweig puts it, “a minnow swallows a whale”. Perhaps the most famous example is the merger between Time Warner and America Online. The latter was, at the time, selling at prices as high as 164 times earnings.

But Time Warner were eager to “get the cachet of an internet darling”. Despite being many times larger, and the SEC’s repeated investigations into America Online’s books, Time Warner justified the price tag.

The merger was, of course, disastrous for Time Warner. America Online’s value evaporated as the dotcom bubble collapsed and its business model faltered. The company was later spun off in 2009 during the global financial meltdown.

The washout and the incorrigible

Indeed, financial history shows us the many ways in which exuberance, salesmanship, and misleading numbers can lead to folly. Looking ahead, can we expect any better or any different? Graham’s himself does not have the fondest of opinions on the crowd:

“The speculative public is incorrigible. In financial terms, it cannot count beyond 3. It will buy anything, at any price, if there seems to be some “action” in progress. It will fall for any company identified with “franchising,” computers, electronics, science, technology, or what have you, when the particular fashion is raging.”
Ben Graham. (1973). The Intelligent Investor.

Graham then goes on to say:

“The shareholders are a complete washout. As a class, they show neither intelligence nor alertness. They vote in sheeplike fashion for whatever the management recommends, and no matter how poor the management’s record of accomplishment may be…. The only way to inspire the average American shareholder to take any independently intelligent action would be by exploding a firecracker under him…. We cannot resist pointing out the paradoxical fact that Jesus seems to have been a more practical businessman than are American shareholders.”
Benjamin Graham. (1973). The Intelligent Investor.

Well, I guess it’s true. We can’t all be as wise as Ben Graham, or Warren Buffett and Charlie Munger for that matter. They are successful stewards and bellwethers of capital for good reason. The average investor’s only chance, I think, is to learn from them and to apply their principles with some sense and luck to the best of their ability. A bit of humility and intellectual honesty can go a long way.

Sources and further reading

Graham, Benjamin., & Zweig, Jason. (1973). The Intelligent Investor.
Kay, John., & King, Mervyn. (2020). Radical Uncertainty.

Ben Graham on Intellectual Honesty, Financial Landmines and Tottering Giants