How Ben Graham’s Framework Helped Me Earn 36% p.a.

In Chapter 5 titled “Classification of Securities” in his masterpiece “Security Analysis,” the author and my teacher Benjamin Graham rejected the conventional classification of securities into bonds, preferred stocks, and common stocks. Instead, he advised readers to focus not on titles but on economic substance of the security being examined. Graham suggested the following framework:

Classification of Securities: Ben Graham's Framework

This is an incredibly useful framework for practical security analysis for it teaches you to focus on the underlying reality and not on legal claims and titles and names. For instance:

  1. When is a stock not a stock but more like a bond? Imagine a stock which pays a dividend of Rs 6 per share, and earns Rs 12 per share, but sells in the market at Rs 60. Imagine further that such a stock is capable of continuing to earn Rs 12 and pay Rs 6 as dividend indefinitely. Under these circumstances, can one not think of the dividend stream of Rs 6 per annum as if they were “bond coupons” on a perpetual bond. If so, what would be the value of this stream of “bond coupons?” Well, if the current rate of interest is 10% p.a., then a perpetuity of Rs 6 per annum is worth Rs 60 today. So the “stock” which sells at Rs 60 can be thought having a “bond component” embedded inside it which has a claim to only half the company’s earnings and yet it alone is worth the current stock price. In other words, using Graham’s framework, one can “see” the “hidden bond component” inside dividend paying stocks having high dividend covers.
  2. When is a bond not a bond but more like a stock? Imagine a convertible bond issued at 100 carries a coupon of 10% p.a. (the going rate of interest in India), to be redeemed at Rs 100 in 5 years but which is convertible at any time in its 5th year into 2 equity shares of the issuer. Imagine that 4 years in the life of the bond are over and now the stock sells at Rs 200. Since the conversion value of this bond is Rs 400 which is four times its face value, such a bond is a bond in name only. It will behave in the market like the stock of the company. According to Graham, such a convertible bond, should be treated like a stock and bought only after careful equity analysis.

I think its terribly important for fundamental investors to incorporate Graham’s framework while analyzing securities.

I find one class of securities under Graham’s framework as very interesting. These are Type II (A): Senior Securities of variable value type: Well-protected issues with profit possibilities. These are fixed income securities where there is a very good chance of earning an yield to maturity which is significantly higher than one offered by the promised coupon on the instrument. The example below will illustrate.

In July of 2008, Ankur, my colleague (who worked on this idea) and I started buying compulsorily redeemable preference shares (CRPS) of Sakuma Exports at about Rs 60 per share. This security issued by this commodity trader (risky business model), had features of Graham’s Type IIA: Well Protected Issues with Profit Possibilities. This wasn’t a plain vanilla high grade debt security. Had that been the case, it would have been classified as a Type I security.

Instead, this was a case of Type II A security because it was worthy of a high credit rating, so far as credit quality was concerned, and yet it was selling at an abnormally low price of Rs 60 levels in July 2008. The promised redemption price was Rs 100 in Feb 2011. In addition we were promised dividends of Rs 5 per share every year. If, and it was a big if, the company would honor its promise related to the CRPS, the yield to maturity was excellent.

How did we analyze the credit risk? It was easy. While this company was conducting a risky business of commodity trading, it had zero debt and had cash on its balance sheet in excess of the value of equity and CRPS combined. The total funds required for the promised redemption were already in possession of the company. We started buying.

Two subsequent events re-inforced our belief that the credit risk was negligible and that the market was wrong in pricing this instrument at such a low price. These were (1) the company’s decision to skip its dividend on common stock in order to “build reserves to redeem preference shares by 2011”; and (2) insider buying of CRPS by the promoters.

There is an apparent paradox in (1). When a company skips its dividend, markets assume the worst. While skipping dividends may be bad news for the minority owners of a firm, its good news for its lenders because every rupee not paid out as dividend is a rupee available for debt service.

Point (2) was terribly important to us because we asked this question: “Why would promoters buy the CRPS from the market if the company was going to default on redemption?”

Ankur and I felt that the insider buying was very solid confirmation of our investment thesis and we started buying aggressively. Indeed there were several days when the entire traded volume was shared between the buying being done by the promoters and us. See chart below which shows the price movement of the security over time.

Sakuma Exports CRPS

We stopped buying at Rs 85 in December 2009. As per our expectations, the company never defaulted on the promised dividends and we collected three dividends of Rs 5 each, and one dividend of Rs 4.58 for the period 1 April 2010 to 28 February, 2011. This final dividend, along with the redemption money of Rs 100 per CRPS came in yesterday.

Since dividends are tax free in the hands of the investors, these should be grossed up in order to accurately calculate the pre-tax IRR earned on this operation, which, according to my calculations comes to 36% p.a – all from a fixed income security with profit possibilities mistreated by the market as if it was junk bond with a very high default risk.

15 thoughts on “How Ben Graham’s Framework Helped Me Earn 36% p.a.”

  1. Sir,

    I have noticed Sakuma (CRPS) initially at Ankur Jain’s blog (it doesn’t look like its functioning now) and forgotten the info…After long time , I noticed Sakuma Share (not CRPS) again which was trading at below Cash..Bought some for personal portfolio…Exited at 50% gain…Though I did a sloppy analysis (didn’t subtract the cash reserved for CRPS redemption..)

    Anyway thanks Mr Bakshi and Ankur for the invaluable education.


  2. Hello Sir,
    I would like to draw your attention to one more such securities “Network18” P2. or 700132. The redemption is in may2013. it has a coupon rate of 5% and face value of 150/-. It is availiable at Rs 99 – 100 giving a yield of around 22% without incorporating the dividend. it has not paid its dividend since issue . The Dividend is cumalative. If the company declares dividend in next 2.5 years, there can a windfall gains and the yield will be around 45 %. (7.5 * 5 years)

    Network 18 is the holding company of CNBC Tv 18 and other channels like colors and

    There is loss in the books and probability of dividend in near future is blink. but principal repayment is not an issue.

    Do give critical comments and feedback


    Jigam Gandhi

  3. Thats a dangerous trade Jigam. I have made money in another earlier arb created out of a whole panoply of securities created by the various companies floated by Mr. Behl. But that was a trade involving zero credit risk.

    The trade you have written about is full of very substantial credit risk, although I have met an ex-student who disagrees with me. The truth is that the current financial strength of the group is precarious. There are losses and leverage and impending redemption pressures on the group. It’s not a trade I like.

  4. Reagrding Network18, one should also consider the pending restructuring which should fortify in months to come, before taking investment decision in the above.

    Around 2008-09, there was a similar opportunity available in Tata Steel CCPS. While there was some assured dividend/interest payout pending, one could acquire Tata Steel EQ at almost 15-20% disocunt and also get the dividend/interest. It was also possible to pocket the difference, by buying the CCPS and shorting Tata Steel in futures.


  5. Hi Aman,

    In the trade of long Tata Steel CCPS and shorting the stock in futures, was there a “seedha badla” or “ulta badla” ?

    In seedha badla, every time you rollover your position in the future , you make money on the premium available but in ulta badla, the next month future sells at a discount to the current month futures, so every time one rolls over the position in futures, one loses money. This discount over the period of the arbitrage position eats up a large part of the spread.

  6. Hi

    Am just curious if there is a way to find all the non-equity securities (warrants/CCPS etc) traded on BSE/NSE

  7. from where did u get the info about the promoters where buying their CRPS if it is in the bse or nse site u got the info can u plz share?

  8. I remeber that this security was illiquid, added to this promoters were buying aggressively, and bid-ask spread used to be very high, tried to buy on several ocasions but with out any success. Execution of this trade might have been a tough task.

  9. dear sir

    i have been following your blog and found it very informative .

    bg srinivas

  10. Dear Professor,

    This is the first time in my life that I have seen almost exact transcripts of the classroom sessions available on internet. In other words there is no need of taking notes in class and even if something was missed in the class one can come and see the detailed transcript here.
    This is the finest example of innovation I have seen in the education system. Revolutionary !!
    And the icing on the cake is your flawless delivery presentation and the hold on the subject.
    Not to forget the Pizzas offered in the break !! It was a sheer delight to listen to your profound lectures.

    In the above analysis you have mentioned that at one time entire volume was being shared by you and the promoters. In case promoters stopped buying then wouldn’t it be a risk for you ? Who would buy your stocks ?

    Thanks & regards-

  11. And does it make sense to buy the ordinary stock now at the level of Rs 15 ? The no debt and good cash reserve factor still make it look attractive pick for a long term.

  12. Thanks a lot Sir

    This post along with your comments on SJVN in one of your presentation, helped me to view SJVN and NHPC more as a perpetual debt, with possibility of future gain. So I thought a part of money which I want to invest in FD, I can very well invest in issues which provides high dividend yield along with possibility of future gains.

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