by Frederik Vanhaverbeke
In the latest of a new series for SBM Frederik Vanhaverbeke, author of Excess Returns: A comparative study of the methods of the world’s greatest investors, looks at how some of the world’s greatest investors are so successful.
The speculative public is incorrigible. It will buy anything, at any price, if there seems to be some “action” in progress. It will fall for any company identified with “franchising”, computers, electronics, science, technology, or what have you, when the particular fashion is raging.
—-Benjamin Graham
Warren Buffett has repeatedly said that his investment style is 85% Benjamin Graham and 15% Philip Fisher. Fisher was discussed in my previous article in the series of top investors that are featured in my book Excess Returns: a comparative study of the methods of the world’s greatest investors. Now we look at Benjamin Graham.
Graham was an investor who also taught deep value investing at Columbia Business School. Buffett admired him, which had much to do with the fact that Graham’s ideas on investing were a true revelation for Buffett after he had searched fruitlessly for a recipe to beat the market. Although not all great investors praise the investment acumen of Graham (see e.g., my article on Charles Munger), his teachings definitely struck a sympathetic chord with many of his pupils. Several of them were highly successful investors when they struck out on their own after taking classes with Graham (see table below). And within his own investment partnership, he racked up a return of 21% a year between 1936 and 1956, beating the market by 9% a year.
|
|
Period |
Number of years |
Annual compound return |
Annual compound return S&P 500 (incl dividends) over same period |
|
Warren Buffet |
1957-2014 |
57 |
22.3% |
9.8% |
|
Walter Schloss |
1951-2000 |
49 |
20% |
13.6% |
|
Tom Knapp |
1968-1983 |
15 |
19.6% |
8.4% |
|
Bill Ruane |
1970-1984 |
14 |
16.9% |
9.4% |
Table: Track records of some very successful pupils of Benjamin Graham.
Benjamin Graham’s investment approach was highly influenced by his traumatising investment experience during the market collapse of the early 1930s. He got bullish too early and sustained serious losses in the string of vicious bear markets between 1929 and 1932. He therefore vowed to play on the defensive for the rest of his life, and championed an investment style that must be seen in that light.
Needless to say, Graham discounted the value of growth heavily and focused his attention on the balance sheet. He steered clear from IPOs, which in his opinion usually come to the market at high prices and are purchased by fickle people who don’t know what they are doing. He also warned investors not to touch small speculative stocks that haven’t proven anything, especially when a bull market is heating up.
Graham
Benjamin Graham was one of the first people to formulate a sound investment philosophy. In his words, “in the short run the stock market is a voting machine, but in the long run it is a weighing machine.” This statement means that although stock prices tend to move randomly over the short term they invariably revert to their intrinsic (fair) value over the long term. In other words, while short term price movements are contaminated by noise, stock prices always track a company’s business success or failure over the long term. The task of the investor is to take advantage of the noise by buying stocks below their intrinsic value and by selling them when they trade at or above that value.
As another part of his value investment philosophy, Graham described market behavior through the allegory of the manic-depressive Mr. Market.
On some occasions Mr. Market is downbeat and wants to sell you shares at cheap prices. On other occasions Mr. Market is euphoric and asks you to pay up (too much) for shares. The task of the intelligent investor is to ignore the mood swings of Mr. Market and insist on a rational price. Whereas the average investor is swept away by market folly caused by the mood swings of Mr. Market, disciplined investors take advantage of them by buying low and selling high. Put otherwise, Graham urged investors to be fearful when others are greedy and to be greedy when others are fearful.
Another major contribution of Benjamin Graham to value investing is his concept of a “margin of safety.”
As the determination of the intrinsic value of a stock is as much art as science, investors must protect themselves against errors when they estimate that intrinsic value. Graham recommended to only buy a stock at a sizable discount (of say, at least 30%) to its (estimated) intrinsic value. The discount not only provides a cushion against valuation mistakes, but also ensures that the buyer can earn an excess return on the stock when the gap between the stock price and the intrinsic value closes. In theory, the intrinsic value of a stock is the sum of the discounted cash flows that accrue to the investor. But in his time, Graham used another very conservative yardstick: the Net Current Asset Value (NCAV) per share. He defined NCAV as the company’s current assets (= cash & cash equivalents + inventory + receivables) minus all liabilities and preferred stock.
Graham’s fundamental analysis was limited to a scrutiny of the financial statements.
He looked for companies with “reasonably satisfactory” earnings records and prospects. He wanted to see, for instance, no earning deficits and reasonable earnings growth (e.g., 30%) over the last ten years. He also didn’t like leverage and wanted common and preferred equity to be higher than the sum of current liabilities and long-term debt (except for companies in very defensive industries). Another factor that he paid special attention to was dividends. Graham saw an uninterrupted record of dividend payments over the past twenty years as a telltale sign of business quality.
It is fair to say that Graham was a pioneer of quant investing. He recommended investors to have between 25% and 75% of their portfolio in stocks (and the remainder in cash and bonds), and to vary the proportion of bonds and cash versus stocks based on a mechanical method. He would sell stocks when they advanced and increase the weight of stocks when the market went down. In his stock portfolio he looked for companies that met a number of quantitative criteria (in terms of valuation and fundamentals), while largely ignoring qualitative factors such as management or a company’s competitive position. Due to this approach, Graham’s knowledge about each individual stock was limited, and wide diversification was the name of his game. In fact, Graham typically spread his portfolio over about 100 bargain issues.
His expression of the basic investment philosophy, the introduction of the concept of margin of safety, and his insights into the psychological requirements to succeed in the market deservedly earned him the title of “Father of Value Investing.”
Having now discussed three investors that shaped the investment approach of Warren Buffett, we move on to the master himself in the next article.