Ben Graham Did Not Give Up on Value Investing in Theory

Hi David,

Love the blog. I am an MBA student and obsessed with the value investing philosophy. There are two points that  could use clarification.

  1. There are so many value investors today, does that mitigate potential rewards? Does value investor competition create less value?
  2. Towards the end of Grahams career he said ” I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities”  This was disheartening to read, but I saw that Jason Zweig commented that Graham was only referring to passive investors.Graham seems to imply otherwise. Any thoughts?

I would really appreciate a response.

All the best.

So wrote one of my readers.  I’ll try to answer both of the questions.

The answer to the first question is relatively simple.  Any strategy can be overused relative to the degree of mispricing in the market.  There can be too many value players.  There can be too many momentum players.  There can be too many investors aiming for dividends, low volatility, high quality, etc.

If you are the only one with a strategy, you can make a ton off of it.  Think of Ben Graham back in the 30s, 40s & 50s… there were few people kicking the tires on seemingly troubled companies that had a lot of unused assets.  It was easy to make a lot of money in that era, for the few that were doing it.

Phil Fisher was a growth investor with a singular insight — look for sustainable competitive advantage, or in the modern parlance, a moat.  He racked up quite a track record in the process.

Or think of Sam Eisenstadt who developed the core of Value Line, building on the ideas of Arnold Bernhard.  He was way ahead of GARP investing by incorporating price momentum, earnings momentum, earnings surprise and valuation into one neat method.  It took a long time before those anomalies were exhausted.  It worked for 50 years or so.

Or think of Buffett, who synthesized many strands of value investing together with an insurance holding company, levering up value investing with an aim of rapid compounding of profits.

Any valid strategy with few users will reap relatively high rewards.  When lots of people pursue it, relative rewards fall.

Value investing has two things going for it that tends to reduce the tendency for the rewards to be played out.  It takes effort, and it’s not sexy.

Value investing can be taken to as deep of a level as one wants.  Sometimes I read the analyses of other value investors, and I say to myself, “This is either masterful, or he had a lot of time on his hands.”  I tend to be more simplistic, realizing that the first 20% of the analysis releases 80% of the value.  I am also a better portfolio manager than I am an analyst, though I’ve had people say to me that my intuition is sharper than many.  (I don’t know.)

The “not sexy” aspect of value investing partly stems from a desire to invest in things that are growing rapidly, because there have been notable growth companies that have made their investors a lot of money.  Why else do you see articles “This stock is the next Microsoft, Apple, Google, etc?”  Creating the next Chevron, IBM, or Berkshire Hathaway would take a lot of time, relatively.

Every now and then, value investing gets crowded, but the advantage never fully goes away for a long time.  Besides, market events like 1973-4, 1979-82, 1987, 1998, 2002-3, and 2008-9 shake up things so that there are a crop of new opportunities.  As I said to my boss in 2007 when he was giving me a bad review, “When I came here in 2003, it was as if the applecart had been knocked over, and easy values were easily picked up, like apples.  Today, there are no easy pickings.”

Okay on to question 2.  Part of the problem here is the famous part of what Graham had to say is well-known but the whole article is not well-known.  Here is the whole article.  And here is the famous quote, again:

In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?
In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

On the face of it, to a value investor, this is rather disheartening.  Who wants to see the founder abandon the heritage? But I mostly agree with Jason Zweig, because this has to be taken in context with the other things he said in the FAJ article.  Let me explain:

First, since Ben Graham, we have discovered a wide number of anomalies in investing: earnings quality, momentum, distress, asset shrinkage, share shrinkage, neglect, etc.  We haven’t been impoverished because we no longer have net-nets (cheap companies with unused assets) to invest in.  We’ve sharpened the discipline beyond what Ben Graham could have imagined.

Second, if you read the full article, Ben Graham still defends value investing:

Turning now to individual investors, do you think that they are at a disadvantage compared with the institutions, because of the latter’s huge resources, superior facilities for obtaining information, etc.?
On the contrary, the typical investor has a great advantage over the large institutions.
Why?
Chiefly because these institutions have a relatively small field of common stocks to choose from–say 300 to 400 huge corporations — and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list–say, 30 issues or more–that offer attractive buying opportunities.
What general rules would you offer the individual investor for his investment policy over the years?
Let me suggest three such rules: (1) The individual investor should act consistently as an investor and not as a speculator. This means, in sum, that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase–in other words, that he has a margin of safety, in value terms, to protect his commitment. (2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase–say 50 to 100 per cent–and a maximum holding period for this objective to be realized–say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market. (3) Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings.
This is value investing.  What Graham is suggesting won’t work is that big investors who have a lot of money to put to work will be forced into big names that are over-analyzed.  He is not saying that analysis of less followed names won’t work; the small size of the individual investor is an advantage, not a curse.
Then Ben Graham says:
What general approach to portfolio formation do you advocate?
Essentially, a highly simplified one that applies a single criteria or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole–i.e., on the group results–rather than on the expectations for individual issues.
Can you indicate concretely how an individual investor should create and maintain his common stock portfolio?
I can give two examples of my suggested approach to this problem. One appears severely limited in its application, but we found it almost unfailingly dependable and satisfactory in 30-odd years of managing moderate-sized investment funds. The second represents a great deal of new thinking and research on our part in recent years. It is much wider in its application than the first one, but it combines the three virtues of sound logic, simplicity of application, and an extraordinarily good performance record, assuming–contrary to fact–that it had actually been followed as now formulated over the past 50 years–from 1925 to 1975.
Some details, please, on your two recommended approaches.
My first, more limited, technique confines itself to the purchase of common stocks at less than their working-capital value, or net-current-asset value, giving no weight to the plant and other fixed assets, and deducting all liabilities in full from the current assets. We used this approach extensively in managing investment funds, and over a 30-odd year period we must have earned an average of some 20 per cent per year from this source. For a while, however, after the mid-1950’s, this brand of buying opportunity became very scarce because of the pervasive bull market. But it has returned in quantity since the 1973-74 decline. In January 1976 we counted over 300 such issues in the Standard & Poor’s Stock Guide–about 10 per cent of the total.  I consider it a foolproof method of systematic investment–once again, not on the basis of individual results but in terms of the expectable group outcome.
Finally, what is your other approach?
This is similar to the first in its underlying philosophy. It consists of buying groups of stocks at less than their current or intrinsic value as indicated by one or more simple criteria. The criterion I prefer is seven times the reported earnings for the past 12 months.  You can use others–such as a current dividend return above seven per cent or book value more than 120 percent of price, etc. We are just finishing a performance study of these approaches over the past half-century–1925-1975. They consistently show results of 15 per cent or better per annum, or twice the record of the DJIA for this long period. I have every confidence in the threefold merit of this general method based on (a) sound logic, (b) simplicity of application, and (c) an excellent supporting record. At bottom it is a technique by which true investors can exploit the recurrent excessive optimism and excessive apprehension of the speculative public.
So, no, Ben Graham did not give up on value investing.  One could easily say that he was arguing for value indexing.  He knew what characteristics of cheapness would lead to superior returns.  He also thought there was room for value investing outside of the largest 400 companies available for investment.
He did recognize that the easy days were gone.  Analyzing liquid assets net of liabilities no longer paid off.  But value investing, buying assets with a margin of safety, and buying them cheap to their intrinsic value was not dead, at least for small investors.  What Ben Graham would have learned had he lived longer was that value investing would adapt, and find new ways of seeking value.  We are you heirs, Ben, and we have built upon your work.
As a final note, though Ben Graham sought “the good life” and was often more concerned with the arts than investing, he was the original quantitative investor.  He recognized aggregate behavior of stocks relative to valuation criteria, and saw that such value investing still worked.  But with individual issues, the “Happy Hunting Ground” of the 30s, 40s and 50s no longer existed, aside from ’74-76.  That’s what Ben Graham meant when he no longer believed in individual security selection for value investing.
PS — When I initially inclined to write this piece, I did not think I would write this.  I thought I would support the mainstream opinion — that Graham gave up on value investing. I can now tell you that that view is wrong. :D  Very wrong.

 

Full disclosure: Long BRK/B, CVX

2 Comments

  • Greg says:

    In a speech he delivered at Columbia Business School (The Super Investors of Graham and Dodds-ville), Warren Buffett told of his experiences with Ben Graham.

    While Buffett apparently did quite well in Graham’s class, when Buffett tried to work for Graham after graduation (reportedly offering to work for free) — Graham refused to hire Buffett (at least according to Buffett’s speech at the time). Buffett tells a similar version of the story in his introduction to the book “The Intelligent Investor”

    In his older years and after Graham’s contemporaries passed away, Buffett has claimed that he chose to go back to Nebraska instead. History being revised to match the legend.

    The lesson I would take from this, historical revisionism aside, is that you have to find a both a broad strategy (value in this example) *AND* you need tactics that match your own personality and the time period you are living in.

    Graham wanted to “trade” individual stocks with a 6-18 month horizon, and sell them once the value was recognized. In that sense, Graham was a speculator (buying with the intent of selling at a higher price).

    Buffett, at least in his early days, tried to buy large pieces of profitable businesses. He said his favorite holding period was “forever” — a clever way to compound returns tax free. As Berkshire became huge and very visible, Buffett hasn’t been able to continue his earlier style. He can’t accumulate shares without triggering copycats; he has resorted to a lot of insider deals (by “insider deals”, I mean deals not offered to the public — not the same as insider trading)

    Both men (Graham and Buffett) used the ideas of value investing — but they had very very different tactics for implementing value investing. Professor Graham seems to have understood this before student Buffett did.

    Value investing lives on. Ben Graham’s style worked best in a market where P/E’s averaged in the high single digits, and the style would not work today.

    Warren Buffett’s style worked best in a period of debt expansion on a national (and global) level. Buffett didn’t take on lots of explicit debt, but the companies he invested in sure do. Buffett bought the companies inside an insurance company wrapper that allowed cheap borrowing (free float from premiums paid) as well as tax compounding advantages. The era of ever-expanding debt is arguably over (at least in the next few decades) — whether debt levels decline or stay level, they certainly cannot expand like they have over the last four decades. Buffett’s *style* of value investing won’t work going forward — but value investing using some other style(s) still work.

    I would ask yourself how to implement value investing in an era where debt is no longer expanding. Arguably an era where inflation is increasing (albeit from a low starting point).

    A few years ago, everyone “knew” housing prices never went down nation wide. Today, CNBC constantly tells us that the consumer is 70% of the economy… undoubtably true when debt levels were expanding. But consumer income is not growing as fast as the cost of living, and debt levels cannot expand again. The “consumer is 70% of the economy” assumption probably won’t hold over the next few decades like it did in the past few decades. How does one implement value investing in such an environment?

  • Panskeptic says:

    What no one wants to talk about is that Graham acknowledged that his business partner, Jerry Newman, made all their money, and he was a growth stock investor.

    Value investing makes you feel virtuous but Fama/French notwithstanding, growth stocks produced the return in Graham’s company.

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