Out of curiosity, I went digging for more info on the strategy Ben Graham used in his early fund back in the 1920s.
As was pointed out in the last post, he was buying undervalued stocks (the long-only portion) found through his own fundamental analysis, along with a separate hedging strategy, and some margin debt thrown in for good measure.
There’s was nothing really funky going on beyond that. Graham was very much focused on risk — minimizing losses — but, unlike his post ’29 strategies, he clearly was trying to maximize gains too.
In an article written in 1920, Graham outlined his hedging strategy.
What we have in mind is the simultaneous purchase of one security and sale of another, because the first is relatively cheaper than the second. Where the security bought sells lower than the one sold, there must be good reason for believing that the price of the two will come closer together — and conversely for the opposite cirumstance.
Without further tarrying on the general theory involved, let us hasten to a concrete example. On November 2, last, let us say, we purchase $10,000 of Lackawanna Steel convertible 5 percent bonds, due 1950, and at the same time sell short 100 shares of Lackawanna Steel stock at 100. Should Lackawanna continue its head long advance, we might be forced to convert our bonds into stock, in order to make delivery of the shares we sold. In this case our operation would have proved unsuccessful — we should have lost $25 and commissions. But if the stock declines it is evident that the bonds will not suffer as severely, because their investment rating alone assures them of a certain minimum value. In actual fact, at this writing the stock is down to 83, while the bonds hold firm around 94. We could therefore undo our little operation by selling the bonds for $9,400 and buying back our stock for $8,300. This would show a net credit of $1,100, from which expenses and the original difference of $25 are to be deducted, still leaving a net profit of over $1,000.
Here then was a venture which under the most unfavorable conditions could have shown a maximum loss of only $56.50, but contained by no means remote possibilities of a thousand dollar profit. Not a bad chance, was it? Add further that it required little capital (as the money really tied up was negligible), and that the carrying charge was insignificant since the bond interest almost offset the dividends on the stock.
He offered a few more real examples. One was a done similarly by substituting convertible preferred shares in place of the bonds – so long preferreds, short common stocks. Which is what Graham was doing. The third example was using rights issues in place of bonds.
But what got Graham into trouble — due to complacency — was he started taking shortcuts to limit the cost of the hedge in order to maximize profits. Janet Lowe, in Benjamin Graham on Value Investing, outlined where he went wrong:
Ben Graham’s problems with the Joint Account were intensified by modifications that he had made to his hedging operation. Generally, to protect an investment, he would purchase a convertible preferred stock and sell short the same amount of common stock. If the market rose, Ben would have a long-term gain and a short-term loss. In cases where the market went down, the common declined faster than the preferred, and the hedge could be undone at a nice profit. When the market would recover, however, as it always had, Ben bought the covertible preferred again to reestablish the hedge. Often, the preferred had to be bought at a higher price than it had been sold earlier. Lulled by a long bull market, the practice seemed to unnecessarily cut into profits. Ben began exercising only half of the hedge, covering the short position but holding on to the preferred shares, or at other times, covering the short by only half as much common stock as was necessary to undo the hedge. The adaptations worked well for a long time, despite the elevated risk. Even as the market collapsed, Ben did not sell the covertible preferred shares that he had bought for a hedge, because their prices seemed abnormally low. The short cut was almost his undoing.
The glaringly obvious thing, besides his mistake, is just how inefficient market pricing was in the ’20s compared to today. It was like shooting fish in a barrel and Graham happily pointed it out too:
Discrepancies of this kind occur in almost endless variety and most of them can be availed of to advantage.
Endless no longer describes Graham’s hedging opportunity today. But it also shows that even something that easy, combined with a greedy mistake, can carry big risks.
The Art of Hedging – The Magazine of Wall Street 1920
Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street
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