Graham-Newman Corporation
American investment company founded by Benjamin Graham and Jerome Newman
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The Graham–Newman Corporation was an American investment company founded by Benjamin Graham and Jerome A. Newman in January 1936. It succeeded the Benjamin Graham Joint Account, an investment pool begun by Graham in 1926, and employed the security-analysis methods that Graham developed with David Dodd. Although it was organized as a corporation rather than as a conventional private partnership, it functioned as a professionally managed pooled investment vehicle and was a regulated investment company under federal law.
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Company headquarters at 122 East 42nd Street, New York City | |
| Type | Investment company |
|---|---|
| Industry | Investment management |
| Predecessor | Benjamin Graham Joint Account |
| Founded | January 1936 |
| Founders | Benjamin Graham Jerome Newman |
| Defunct | 1962 |
| Fate | Voluntary liquidation; investment operations ended in 1956 |
| Headquarters | New York City, New York, United States |
| Products | Investment fund |
Graham–Newman bought securities trading below its estimate of intrinsic or liquidation value and also undertook merger arbitrage, corporate liquidations, convertible-security hedges and control investments. Its best-known transaction was the 1948 purchase of a controlling interest in the Government Employees Insurance Company (GEICO), shares of which were subsequently distributed to Graham–Newman stockholders. The firm also became an important training ground for investors including Walter Schloss, Warren Buffett and Tom Knapp. Graham retired from active money management in 1956, whereupon the shareholders approved liquidation. Residual assets were administered through a liquidation trust; a final distribution followed in 1960, and the U.S. Securities and Exchange Commission reported in 1962 that the corporation had been dissolved.
History
Predecessor account, 1926–1935
On January 1, 1926, Graham left his existing arrangement at Newburger, Henderson & Loeb and established the Benjamin Graham Joint Account with approximately $400,000 to $450,000 supplied largely by friends and former clients.[1][2] Jerome Newman joined the organization during 1926 and became Graham's equal partner in 1928.[3] The account rose to about $2.5 million before the Wall Street Crash of 1929, but sustained severe losses between 1929 and 1932.[4][5]
The Joint Account's experience during the Depression influenced the founders' later emphasis on balance-sheet strength, diversification and a margin between purchase price and appraised value. In 1934 Graham and Dodd published Security Analysis, which distinguished investment from speculation and formalized many of the techniques employed in the account.[6][7]
Incorporation and organization
Graham and Newman incorporated the Graham–Newman Corporation in New York in January 1936, transferring the continuing investment operation into a corporate fund.[8][9] The corporation's shares pooled capital from outside stockholders, while Graham and Newman managed the portfolio and received salaries plus contingent compensation tied to profits above a specified threshold.[10] The compensation formula varied over the company's life, but generally linked additional pay to realized earnings and distributions to stockholders rather than simply to assets under management.[11][12]
The company was treated as a regulated investment company for federal tax purposes and registered under the Investment Company Act of 1940.[13] Later descriptions have called it either an open-end mutual fund or the functional equivalent of a closed-end fund; Buffett described it as "technically" open-end, while noting that its fixed pool of capital and investment style differed from a typical modern mutual fund.[14][15]
The firm maintained a deliberately small organization. By August 1955, Buffett recalled, three managers—Graham, Jerome Newman and Newman's son Howard—supervised five employees, two of whom were secretaries.[16] Graham served as chairman in the final years, Jerome Newman as president, and Howard A. Newman as vice-president, treasurer and secretary.[17] Its New York office was at 52 Wall Street in the late 1940s, at 120 Wall Street by 1950–1951 and at 122 East 42nd Street from 1952 through liquidation.[18][19][20]
In 1949 the principals also formed a separate limited partnership, Newman & Graham, initially capitalized at approximately $2.57 million. It pursued similar investments and shared operating expenses with the corporation in proportion to their capital.[18] By the mid-1950s, Graham–Newman and the affiliated partnership together managed about $12 million.[21][22] The two vehicles were legally distinct: Graham–Newman was the regulated corporate fund, while Newman & Graham was a private partnership resembling what would later be called a hedge fund.[14]
Investment approach
The 1946 annual report summarized the corporation's policy as purchasing securities below intrinsic value as determined by analysis—with special emphasis on issues trading below liquidation value—and conducting arbitrage and hedging operations.[10] Management placed relatively little reliance on forecasts of the market or on predictions that a company's future would differ substantially from its past. In general portfolio operations it sought to buy during pessimistic periods and sell when optimism and prices were high.[10]
Graham later divided the operations practiced from 1926 through 1956 into several recurring groups:
- Arbitrages: purchasing a security to be received in a merger, recapitalization or reorganization while simultaneously selling the security into which it was expected to be exchanged;
- Liquidations: purchasing shares expected to receive one or more cash or security distributions as a company wound up;
- Related hedges: purchasing convertible bonds or preferred shares while selling short the common shares into which they could be converted;
- Net-current-asset issues: diversified purchases of common stocks priced below their net current asset value after deducting all liabilities;
- General investments: securities selling materially below appraised intrinsic value; and
- Control operations: positions large enough to influence management, distributions or a corporate reorganization.[23]
For announced arbitrages and liquidations, the firm generally sought a calculated annual return of at least 20 percent and an estimated probability of completion of at least four chances in five.[23] Buffett later examined the firm's arbitrage ledger for the full 1926–1956 period and reported that the unleveraged returns on those identified operations averaged about 20 percent annually.[24]
The mix changed with market conditions. In 1946 management said that the scarcity of qualifying common-stock bargains in a rising market had shifted more capital toward arbitrage, liquidation, hedging and convertible securities.[10] The succeeding reports show the portfolio being rebalanced among industrial common stocks, railroad and other bonds, preferred shares, arbitrages and cash as valuations and special situations changed.[25][26]
The approach was not purely passive. Graham's pre-corporation campaign at Northern Pipe Line sought the distribution of surplus securities to stockholders, and Graham–Newman later used significant holdings and board representation to press for changes or unlock assets.[27][8] These activities have led later writers to identify Graham as an early practitioner of shareholder activism as well as value investing.[7]
Notable investments
GEICO
In 1948 Graham–Newman joined E. R. Jones & Company and investor David Lloyd Kreeger in purchasing the interest in GEICO held by the Rhea family. Graham–Newman's portion—1,500 pre-split shares, representing approximately half of GEICO—cost $712,500, close to one-quarter of the investment company's assets.[3][28] The price was approximately 10 percent below book value, but the purchase was unusually concentrated by Graham–Newman's standards.[23] Graham and Newman joined the insurer's board and remained associated with GEICO after the shares left the fund.[29]
The size of the holding conflicted with restrictions applicable to registered investment companies. With SEC approval, Graham–Newman therefore distributed the GEICO shares pro rata to its own stockholders in July 1948 rather than retaining the controlling block.[30][13] GEICO consequently acquired a dispersed outside ownership and an over-the-counter market. It subsequently grew into the most valuable investment associated with the fund; in the 1973 edition of The Intelligent Investor, Graham wrote that the profits ultimately attributable to the GEICO interest exceeded those from all the firm's other operations over the preceding twenty years.[23] Berkshire Hathaway, led by Buffett, completed its acquisition of GEICO in 1996.[31]
Rockwood & Company
In 1954 Graham–Newman participated in a special situation involving Rockwood & Company, a Brooklyn chocolate-products manufacturer. A spike in cocoa prices had made Rockwood's inventory far more valuable than its carrying value, but an outright sale would have produced a large tax liability. The company instead offered shareholders cocoa beans in exchange for stock. Buffett, then a newly hired analyst, was sent to Rockwood's stockholders' meeting and studied the transaction for Graham and Newman.[24][32]
Philadelphia and Reading
Graham–Newman began acquiring shares of the Philadelphia and Reading Coal and Iron Company in the early 1950s. The anthracite concern possessed substantial cash and tax-loss carryforwards despite a declining operating business.[26][16] Working with allied shareholders, the fund obtained board representation and eventually control. In 1955 the company, renamed the Philadelphia and Reading Corporation, acquired Union Underwear, a manufacturer and licensee of the Fruit of the Loom brand, for $15 million; the purchase used cash, the target's own funds and non-interest-bearing notes.[16] Howard Newman became president of Philadelphia and Reading, which survived Graham–Newman's liquidation and later developed into a diversified industrial concern.[33]
The corporation also reported significant positions or control interests over time in companies including Plymouth Cordage, Pepperell Manufacturing, Marshall Wells, National Container, North American Rayon and the Atlantic Gulf and West Indies Steamship Lines. The annual reports distinguish such general portfolio investments from arbitrages and positions held in liquidation.[19][11][20][17]
Personnel and investment lineage
Graham combined the company's work with teaching security analysis at Columbia Business School. His academic and business roles overlapped: Dodd served as a Graham–Newman director, and students and associates were introduced to the same emphasis on financial statements, intrinsic value and a margin of safety.[34][35]
Walter Schloss joined the firm after taking Graham's evening course at the New York Institute of Finance. He worked as a securities analyst for approximately nine and a half years and left in 1955 to establish Walter J. Schloss Associates.[36][37] Tom Knapp later became a partner of Tweedy, Browne, which incorporated Graham's quantitative selection methods into its investment process.[37]
Buffett studied under Graham at Columbia and joined Graham–Newman in August 1954 after Graham had earlier declined his offer to work without pay. Buffett worked for both the corporation and Newman & Graham, researching undervalued securities and special situations, until the organizations wound down in 1956.[22][38][39] When Graham announced his retirement, he offered Buffett an opportunity to continue the fund as junior partner to Howard Newman, but Buffett chose to return to Omaha.[40] Buffett later described four junior employees at the firm during 1954–1956 as sharing a common "intellectual home"; he used the subsequent records of Schloss, Knapp and himself in his 1984 "Superinvestors of Graham-and-Doddsville" essay.[36]
Performance
The corporation regularly distributed investment income and realized gains, so changes in reported net asset value alone do not measure stockholder returns. Its 1946 report stated that during the preceding decade the company had earned $245 per share before contingent officer compensation against an adjusted original issue price of $99. Of that amount, $161 per share had been paid as cash dividends, $16 represented subscription rights and $27 remained as an increase in net asset value; $41 had been paid as contingent compensation.[10]
Modern estimates differ according to their treatment of distributions, taxes, the predecessor account and the GEICO shares distributed in kind. Jason Zweig calculated that Graham–Newman gained at least 14.7 percent annually from 1936 through 1956, compared with 12.2 percent for the broad stock market.[41] Janet Lowe reported a 17.4-percent annual return before the separate GEICO distribution and about 15.5 percent to stockholders after the fund's charges and distributions.[3] The figures should not be treated as directly interchangeable because they measure different cash-flow series. Buffett's approximately 20-percent figure concerned the firm's arbitrage operations rather than the total portfolio.[24]
Academic research has found that the net-current-asset strategy associated with Graham and used at Graham–Newman produced abnormal returns in later samples, although those studies do not constitute an audit of the corporation's own results.[42] Financial historians have similarly treated the fund as a practical demonstration of Graham's analytical approach, while noting that its size, opportunity set and regulatory environment differed materially from those faced by later institutional investors.[43][7]
Liquidation
In 1956 Graham decided to retire from active money management. The corporation called a special stockholders' meeting for August 20, 1956, at which shareholders approved a plan of complete liquidation.[44] Most shares were redeemed during 1956 and early 1957. Stockholders received cash and, in some cases, securities including shares of Philadelphia and Reading; less readily realizable assets and claims were placed in the Graham–Newman Corporation Liquidation Trust.[45][46]
The trust continued resolving contingent liabilities, including litigation involving the New Haven Railroad. Its final cash distribution was made in December 1960.[3] On January 22, 1962, the SEC announced the corporation's application for an order declaring that it had ceased to be an investment company, stating that it had been dissolved and that all assets remaining after liabilities had been distributed.[47] Accordingly, 1956 marks the end of investment operations, while 1962 is the final regulatory dissolution milestone.
Legacy
Graham–Newman is remembered less for its scale than for joining systematic security analysis to an operating record and for the investors trained there. Its annual reports and partnership documents are preserved in the Benjamin Graham papers at Columbia and in the Graham–Newman Collection of the Museum of American Finance.[34][9] The Museum's collection includes partnership agreements, correspondence, portfolio material and the 1956 dissolution letter.[48]
Buffett repeatedly cited his employment by Graham and Newman as formative. In his 1988 Berkshire Hathaway letter he used Graham–Newman's arbitrage record to challenge a strong version of the efficient-market hypothesis, and in 2001 he used the Philadelphia and Reading transaction to illustrate the lineage connecting Graham–Newman to Berkshire's later acquisition of Fruit of the Loom.[24][16] His 1976 memorial to Graham emphasized Graham's generosity, creativity and influence on the investment profession.[49]
The firm has sometimes been described retrospectively as an early hedge fund because it used short sales, hedged arbitrage and performance-linked compensation.[50][22]