Benjamin Graham as an Early Indexer
Benjamin Graham seemed to be one of the earliest proponents of indexing. By indexing I mean holding a group of stocks based on a fixed set of criterion. I say earliest because I do not know of another, though there could have been. In the quote below he refers to these activities as "group operations". Index funds did not exist for most of Benjamin Graham's career. He tried to own as much of one type of investment that satisfied a set of rules based on his ideas of value. In his writings he mentioned more than once that the average investor would do well to own about 30 stocks that satisfied a certain set of rules. In an article by James B. Rea "Remembering Banjamin Graham - teacher and Friend", Journal of Portfolio Management. He gave two sets of criterion on how to choose stocks. One set about value and the other about financial soundness.
Value
- Earnings Yield less than twice the AAA bond rating,
- P/E value less than 4/10 it's previous high,
- price less than 2/3 tangible book value,
- price below net working capital
Financial soundness
- current ratio more than 2,
- total debt less than companies tangible value,
- total debt less than twice working capital minus long term debt,
- price below networking capital
The article goes on to say that you could get most of the benefit by focusing only on the criterion of low P/E values (less than the minimum of 10 and 1/(2*(AAA bond yield))) and low debt. He also said that dividends are useful. You can see in the above criterion his ideas for low debt but he also mentions a way to approximate it is with a debt to equity ratio of less than 1.
Though he never said explicitely, Benjamin Graham seemed to do this for three reasons: 1. he was skeptical of the return on value that extensive security research produced, 2. he had other interests and was only going after satisfactory results, and 3. As Warren Buffett has mentioned before in Berkshire Hathaway meetings, he was trying to create a useful set of rules that most anyone could follow. Though, in his books, his main audience seemed to be wealthy professionals who had accumulated a large sum of money through their professional activities and had neither formal security analysis training or the time to think about it.
In the early days of his funds, Benjamin Graham focused only on the value portion of the criterion list. His idea of value was the net-net stocks, which were those selling below two-thirds working capital. He did not have the same criterion in the 30s as he did in the 70s. When net-nets started disappearing he changed to valuing securities in relation to the entire market.
In those days they did not have computers to find such stocks. What he did instead was hire security analysts to flip through pages of the Moody's manuals and find stocks with these characteristics. Today we can use screeners.
What would Benjamin Graham think of index funds as we see them today? This first quote is from a series of talks that Benjamin Graham gave between 1946 and 1947 called "Common Problems in Security Analysis". It talks about the idea of buying stocks in groups (based on a unifying idea within that group).
There are great advantages in dealing with a group valuation, because you are more likely to be nearly accurate, I am sure, when you are considering a number of components together-in which your errors are likely to cancel out-than when you are concentrating on an individual component and may go very wide of the mark in that one.
Furthermore, there is nothing to prevent the investor from dealing with his own investment problems on a group basis. There is nothing to prevent the investor from actually buying the Dow Jones Industrial Average, though I never heard of anybody doing it. It seems to me it would make a great deal of sense if he did.
When we talk about buying bargain issues, for example, the emphasis on group operation becomes even greater, because you then get into what could practically be known as an insurance type of operation. Here you have an edge, apparently, on each individual company. That advantage may conceivably disappear or not be realized in the individual case; but if you are any good at all as an analyst you ought to realize that advantage in the group. And so I have had a great partiality for group operations and group analysis. I must say, however, that you gentlemen, as functioning security analysts, advisers to the multitude, and so on, are unable to obtain that advantage in all the work you do. For I am sure you are compelled to reach rather definite conclusions about individual companies, and can't hide them in a group result.
In March of 1976, two years after the start of the Vangaurd index fund, in an article called "An Hour with Mr. Graham", he was asked for his thoughts on index funds. He gave said the following:
I have a feeling that the way in which institutional funds should be managed, at least a number of them, would be to start with the index concept-the equivalent of index results, say 100 or 150 stocks out of the Standard & Poor's 500. Then turn over to managers the privilege of making a variation, provided they would accept personal responsibility for the success of the variation that they introduced. I assume that basically the compensation ought to be measured by the results either in terms of equaling the index, say, Standard & Poor's results, or to the extent by which you improve it. Now in the group discussions of this thing, the typical money managers don't accept the idea and the reason for non-acceptance is chiefly that they say--not that it isn't practical-but that it isn't sound because different investors have different requirements. They have never been able to convince me that's true in any significant degree that different investors have different requirements. All investments require satisfactory results, and I think satisfactory results are pretty much the same for everybody. So I think any experience of the last 20 years, let's say. would indicate that one could have done as well with Standard & Poor's than with a great deal of work, intelligence, and talk.