My Review* of Seth Klarman's Ed. of "Graham and Dodd's Security Analysis 7th Ed."

Learning from the Masters

 

Star value investor Seth Klarman has edited an updated version of Graham & Dodd’s investing classic with help from such luminaries as James Grant, Howard Marks, and Todd Combs. Klarman uses the 1940 edition as the basis for his and the other editorial commentaries on the text’s very detailed discussion on security analysis. For most readers the original Graham & Dodd discussion will seem like ancient history to today’s investing world, but for a history buff like me, I found much of the discussion fascinating. (Also see my prior review of Graham Shulmaven: My Amazon Review of Benjamin Graham's and Jason Zweig's (Ed) "The Intelligent Investor (Rev. Ed.)" )

 

The core lesson of Graham & Dodd is that when one invests in a common stock, he or she owns a proportionate share in a business and the value of that business is dependent upon its net assets (shareholders’ equity) and its underlying earning power. The idea is to be able to buy a stock sufficiently below its value to create what Graham & Dodd call a margin of safety. Also timeless is Graham & Dodd’s holding suspect the use of appraised values in real estate debt securities that were so prominent in the 1920’s and again today.

 

For Graham & Dodd earnings power is measured by the average of earnings over the last five or ten years. The future does not really enter into the discussion except if there is a strong upward trend which might allow an investor to pay modestly higher earnings multiple. The authors were especially critical of the 1928-29 new-era philosophy of valuing equities solely on the basis of future prospects largely because the future is unpredictable. Thus, they are critical of John Burr Williams’ 1938 view that the value of a stock equals the present value of future dividends, because, again, the future is unknowable. Nevertheless, in today’s world investing is all about capitalizing future earnings.

 

You have to remember that Graham & Dodd were writing against the backdrop of the Great Depression of the 1930’s. The new-era philosophy of 1928-29 crashed and burned and what investors had to deal with was the here and now of net asset values and historical earning power. However, they did note the price-earnings ratios in 1936-38 were much higher than they were in 1923-25, which they attributed to much lower interest rates. They also wisely noted that the low interest rates of the 1930’s were sending a negative message about the future growth in the economy. In retrospect the high multiples could be attributed to the fact that corporations were under-earning due to the depression.

 

They also seemed to be puzzled about the return to growth stock investing in the late 1930’s. They listed seventeen stocks that were characterized as growth issues at that time. Several of the names would puzzle today’s investor, but I would point out that there were five chemical stocks on the list. The advances in chemistry and chemical engineering in the 1930’s made them the technology stocks of that day.

 

I enjoyed the essays introducing the chapters of the book. However, my criticism of the essays is that they do not include detailed examples of how a Graham & Dodd investor, like me, would utilize the wisdom presented in the book today. For that I would recommend Bruce Greenwald’s “Value Investing: From Graham to Buffett and Beyond 2^nd Ed.” (See: Shulmaven: My Amazon Review of Bruce Greenwald's et.al. "Value Investing: From Graham to Buffett and Beyond" 2nd. Ed.)

*-Amazon has yet again failed to post this review. Amazon just posted my review on 8/17, see Learning from the Masters (amazon.com)

Moody's Lowers the Boom on the Bank Stocks

 Moody's finally acknowledged what most of us new last April that the banks were in a world of hurt. ( See: Shulmaven: Winter Comes to the Bank Stocks ) Last night Moody's downgraded 10 banks including Commerce Bancshares and M&T Bank, put 6 under review including BNY-Mellon, Cullen Frost, Truist Financial and U.S. Bancorp  and placed 11 banks with a negative outlook including PNC and Fifth Third. The rationale for the downgrades was based upon high funding costs, asset risk in commercial real estate, underwater securities holdings and potentially  higher capital requirements. The ratings agency neglected to mention higher FDIC premiums. Moody's also neglected to note that the day will soon come when the Federal Reserve introduces a high inflation scenario in its annual stress test. 

The bottom line here is that the banking crisis engendered by the failure of Silicon Valley Bank and First Republic Bank is far from over with that credit standards will continue to tighten. What will ultimately be needed is a re-equitization of the banking system with its concomitant dilution. The one saving grace is that just like the defense industry's "last supper" hosted by Secretary of Defense William Perry in 1993 which signaled a consolidation of that industry, we now have Secretary of the Treasury Janet Yellen urging the regional and community banks to merge. The anti-merger FTC Chair Lina Khan will stay out of the way.

My Amazon Review of Richard Langlois' "The Corporation and the Twentieth Century.............."

 The Evolution of Corporate America

University of Connecticut economics professor Richard Langlois has written a very long and deeply researched book on the evolution of the American corporation and its interaction with government. The book is spiced up with interesting case studies on RCA, General Motors, Ford, AT&T and Microsoft, for example. His thesis is that economic historian Alfred Chandler and social theorists Berle and Means got it all wrong in their books “The Visible Hand” (1977) and “The Modern Corporation and Private Property” (1932) which credit the modern corporation’s roots to the growing complexity of business and the need for capital, thereby separating management from ownership. Chandler’s prototype is the Pennsylvania Railroad, once the largest corporation in America.

 

Langlois counters Chandler by noting that the great corporations of the early 20^th Century, Standard Oil and U.S. Steel, for example were controlled either by their entrepreneurial owners or their investment banks, JP Morgan in particular. To Langlois it was the momentous events of World War I, the Great Depression and World War II that thrust the administrative state on to American business.  Along the way there was the populist desire to curb monopoly that led to the antitrust laws. Just to note that Langlois is anti-antitrust.

 

The hero in Langlois’ telling is Ronald Coase whose 1937 “Theory of the Firm” established the boundaries around a given business. The critical variable is the role of transaction costs. In essence the firm competes with itself in that if it is cheaper to outsource the firm will outsource and if not, the firm will perform the function in house. Here is where the government enters the picture through antitrust, which prohibits certain types of contracting and with price and wage controls which makes it difficult for the firm to receive the appropriate economic signals. As a result, instead of contracting, firms in the immediate postwar world vertically integrated thereby avoiding antitrust issues, for the most part.

 

However, as the administrative state got called into question in the 1960’s so too did the administrative corporation. Inflation, international competition, and the growing pressure to deregulate the economy forced change. With that what came next was the revolution in financial affairs that brought shareholder value to the forefront. Instead of plodding administrators, corporate executives had to become active managers.  It is interesting to note that during this time graduate business schools changed their names from schools of administration to schools of management.

 

What surprised me is that despite a boatload of footnotes, Langlois does not cite the 1976 Meckling and Jensen paper, “Theory of the Firm,” and Milton Friedman’s 1970 social responsibly of business article.  To me those to papers represent the underpinnings of the intellectual challenge to the Chandlerian corporation of the 1970’s. I must say I am a glutton for punishment; the book is too long for the educated lay reader. Nevertheless, it is worth sticking to it.

For the full Amazon URL see: The Evolution of Corporate America (amazon.com)

Quoted in The Wall Street Journal on Commercial Real Estate

 “Basically, what you have is a decaying asset,” said David Shulman, formerly a real-estate investment trust at Lehman Brothers and now an senior economist at UCLA Anderson Forecast. “If it’s a decaying asset it’s a hot potato that you should get rid of as fast as you can.”  

"Bank Regulators Urge Flexibility in Commercial Real-Estate Loan Workouts as Defaults Grow" 

 The Wall Street Journal (online, paywall), July 24  Bank Regulators Urge Flexibility in Commercial Real-Estate Loan Workouts as Defaults Grow - WSJ

My Amazon Review of Christopher Clark's "Revolutionary Spring: Europe Aflame......"

 Revolution was in the Air

 

Contrary to the “Communist Manifesto” the specter haunting Europe in 1848 was not communism, but rather nationalism.  In this way too long 891-page book the distinguished historian Cambridge’s Christopher Clark recounts the revolutions that swept through Europe in 1848.  Starting in Palermo in the Kingdom of the Two Sicilies and then spreading to Paris, Germany, Vienna, Romania, Hungary, and Poland. Europe was aflame with liberals and radicals demanding fundamental reforms. The liberal goals were limited to formal constitutions, political rights, and suffrage for the property-owning classes while the radicals were demanding full manhood suffrage and a right to a job. In the end the liberals would win out.

 

Clark starts his history with the 1815 Vienna settlement’s reaction to the French Revolution and then goes on to discuss the growing immiseration of the working class as the industrial revolution moves into high gear. The problems of the working class were defined as “the social question” by many of the intellectuals of the day. Falling real wages and periodic draughts characterized the milieu according to Clark.

 

Here is where I believe, as an amateur, Clark goes astray. It seems to me that Clark ignores Marx’s paean to the bourgeoisie in his manifesto. To quote “…has created massive and colossal productive forces…chemistry, agriculture, steam navigation, electric telegraphs and canals.” Again, in Marx’s words, “all that is solid melts into air.” In my opinion Clark should have spent much more time on the technological disruption that created the material basis for the revolutions. Indeed, the improved technology enabled the news of the Paris revolt to spread quickly throughout Europe.

 

The revolutions failed because of the radical-liberal split, the failure to bring the military on board, and the near complete lack of understanding of rural Europe by the urban intellectuals. Doesn’t that sound familiar? Remember Marx himself called it “the idiocy of rural life.”

 

However, the revolutions were in no way a long-term failure. Post-1850 new constitutions were written, Germany and Italy would be unified within twenty years, Jews were largely emancipated, and there were massive public investment programs in railroads, health, roads, and canals. The economy was about to boom and with it the ideas of social democracy and women’s rights took hold. Moreover, the pattern of radical movements centering around cafes and newspapers was firmly established and that would last up to the late 20^th century.

 

This is a massive book and there is much to be learned, but as I noted in the beginning it is far too long for the educated lay reader.

For the full Amazon URL see: Revolution was in the Air (amazon.com)

 

My Review* of Scott Patterson's "Chaos Kings: How Wall Street Traders...................."

 Tail Riders

 Wall Street Journal reporter Scott Patterson has written a book celebrating the exploits of hedge funders Nassim Taleb of black swan fame, and Mark Spitznagel whose successful bets on high impact low probability events made them a fortune. Their strategy is simple and requires a great deal of patience and a high tolerance for pain in that they are continuously long deep out-of-the money put options on the major stock market indices. Most of the time the options expire worthless, but when disaster strikes their value explodes and those monster gains overwhelm the small ongoing losses. In essence Taleb and Spitznagel take positions on the left tail of the probability distribution for stock market returns.

 Although they don’t know when a catastrophe on the order of the 2008 financial crisis or the 2020 Covid collapse would occur, when it does happen, they are positioned for it. Their sales pitch is that they are selling portfolio insurance for a modest premium and that they allow for much higher equity exposures than otherwise would be prudent. Their model is 97% equities and a 3% position in their fund.

 When I was a partner in a hedge fund over two decades ago, we made a similar bet on catastrophe by buying out of the money call options on Eurodollar futures. It was a bet that interest rates would fall. When Long Term Capital Management failed in September 1998 the price of the options increased tenfold.

 Just to note, I previously reviewed Spitznagel’s “The Dao of Capital” and Taleb’s “Skin in the Game.”(See:  Shulmaven: My Amazon Review of Mark Spitznagel's, "The Dao of Capital: Austrian Investing in a Distorted World" and  Shulmaven: My Amazon Review of Nassim Nicholas Taleb's "Skin in the Game: Hidden Asymmetries in Daily Life"  )   Patterson is a skilled writer so he tells their stories better than they can. However, I would quibble with Patterson in that he wanders off into tangents that are really extraneous to the book’s main points.

* Amazon has yet to post this review. Amazon just posted this AM with  

 Tail Riders (amazon.com)

A Big Week for the Supremes

 The Supreme Court closed it 2022-2023 session with a raft of blockbuster decisions. They buried the so-called “independent legislature theory,” supported the voting rights in Alabama, did away with raced-based preferences in college admissions, undid Biden’s usurpation of Congress’ power of the purse in the student loan case and prevented Colorado from interfering with freedom of expression in allowing a web designer to refuse designing a website for a gay wedding. The last one is a harder call but think of the child of a Holocaust survivor being forced to make a web design for a neo-Nazi group.

 

In my nonlawyer opinion I think all of the above cases were decided correctly. I was especially pleased by the ruling in the affirmative action case where all to many elite universities have been practicing a 21^st Century version of the Chinese Exclusion Act of 1882. What proponents of race-based preferences are really trying to do is to offset the failures of K-12 public education. The reason why African Americans and Hispanics are “under-represented” in elite schools is that public education has failed them with a pattern and practice of state-sponsored child abuse aided and abetted by the reactionary teachers’ unions.

 

One last point on this is that I would hope the Supreme Court will soon accept the case of the odious DEI loyalty oath that is now required for hiring and promotion at many elite universities. There is far less justification for DEI loyalty oaths than there was in the 1950’s where faculty had to pledge loyalty to the United States.