I first read about the forefather of value investing, Benjamin Graham, in the late 1990s. In the investing world, value investors have never been in the majority (or even the plurality), but Graham had then, and still has, a strong following. I was interested that a historical figure would have so much influence in modern investing. In a world of computers, instant data, and new economic conditions, I wondered whether Graham’s advice was still applicable. After years of research I came to believe Graham’s teachings were highly valuable, even if some of his formulas were now outdated. Graham’s principles became the foundation for my investment philosophy.
To understand Graham’s relevance today you have to go back to the essential investment building blocks that Graham taught. While Graham’s teachings covered a vast area of investing, these are the five foundational principles to Graham’s philosophy:
1. Investing is most intelligent when it is most businesslike.
2. Nobody can tell the future.
3. The future is something to protect against.
4. Investors are moved in large part by irrational forces.
5. Mean reversion is a fundamental law.
Benjamin Graham famously said that investing is most intelligent when it is most businesslike. That means that an investor must recognize that a stock is just a fractional piece of a business that is traded on the public markets. Since businesses have an intrinsic value, any stock has a discernible value based on the fractional ownership of the business the stock represents. Graham’s most famous student, Warren Buffett, has said that rather than thinking of the stock market as an end in itself, investors should consider the economics of ownership of those businesses that the common stocks represent.
Despite what most people think, it is nearly impossible to tell what will happen in the stock market’s near future. Analysts spend a lot of time reading financial statements and looking at past trends to get a sense of what’s likely to happen. Investors then use these predictions to determine which stock is a worthy investment. I’ve written about this extensively before; past trends tell you the most about what just happened and very little about what will happen.
The Economist recently reported on a study done by Roger Loh and René Stulz who looked at analyst estimates during falling markets from 1983 to 2011. The study concluded that while analysts were inaccurate in bull markets, they were about 50% more inaccurate in bear markets.
Graham understood the draw to, and the problems with, relying on trends to predict the future. That is why he told investors in the 1951 ed. of Security Analysis not to base intrinsic value on trends that have been extrapolated into the future.
Instead of looking to the future to earn a profit, Graham favored protection from future negative events to reduce risk. He did this by looking for margins of safety when purchasing a stock. Margin of safety is one of Graham’s most famous concepts. Graham’s basic idea was that investors should seek out some margin of error that they can use to protect themselves from unforeseen unfortunate events. The best known analogy of Benjamin Graham’s margin of safety concept is that of building a new bridge. If you expect the bridge to hold 10,000 tons during peak hours you would not build it to hold 10,000 tons, you would build it to hold 20,000 tons to create a margin of safety. If it turns out that you were wrong about how much the structure could hold, or the amount of traffic passing over the bridge during peak hours, the bridge would still hold.
Typically, value investors seek out Benjamin Graham’s margin of safety by buying stocks for less than they’re worth. This is the well known price-value discrepancy that value investors love. Since a stock is just a fractional piece of ownership in a business then the share certificate should reflect what that business is actually worth, its intrinsic value. Liquidity and errors in investor judgment mean that shares are sometimes priced either above or below an actual assessment of their true intrinsic value. According to Graham, a margin of safety exists when the shares are trading well below that intrinsic value.
Despite what common held notions, and widely held economic theories, preach, investors and business leaders are not perfectly rational number-crunchers. Everybody is subject to irrational forces when making decisions. Fear and greed are the most cited drives in the field of value investing, and often these two forces can cause investors to bid up the prices of stocks to high levels during a period of good news, or push stocks to unreasonably low levels when bad news hits. Investors often overreact to both positive and negative events, a tendency that Graham was well aware of.
You can often see dramatic swings in the price of stocks. It’s common, for example, for a stock to move 50% from top tick to bottom tick during the course of a year. It’s also common for stocks to suffer large declines in price during bear markets. Graham gave a famous analogy to help you understand the implications of these phenomena. Suppose you’re in business with a man named Mr. Market. Mr. Market, according to Graham, is not well emotionally balanced. Some days Mr. Market is feeling very good about your company’s future, so he offers to buy your share in the business for well above your own estimate of its worth. On other days, however, Mr. Market feels depressed and pessimistic about the prospects of your business. On those days, he offers up his stake in the business at a surprisingly low figure in relation to your own assessment of its worth. You don’t have to agree to any purchases or sales with Mr. Market, if you don’t want to. Graham suggests, however, that his moods are there for you to use to your advantage.
Social proof is one reason investors will swing between overly-optimistic and overly-pessimistic appraisals of a stock. If the market is in the middle of a long steady rise then investors will tend to feel left out and want to join in on the fun. Or on the flip side, if everyone is dumping a stock, most investors will take that as proof that it’s time to sell, even if fundamentals don’t agree.
Commitment is another troubling factor. As Graham pointed out, once someone makes a positive assessment, a positive prediction, of what is likely to happen, he is more likely to seek out confirming evidence and ignore contrary evidence. This makes it tough to sell. If he states his assessment publicly then it becomes that much harder, and he also encourages others to buy. This cycle continues until some negative event pops the bubble and the market turns. Once panic sets in, those effected by social proof run for the door. Eventually, social proof even consumes many who felt commitment to their original purchase and the stock falls far below its intrinsic value.
Markets and stocks don’t stay at the bottom. Graham was well aware that reversion to the mean is a powerful force in the business world just like it is in the natural world. Mean reversion means that over time results will tend toward some average. In business, markets tend to revert back to a typical level of profitability over time. Sectors that are suffering from poor profits tend to increase their profitability over time while sectors with exceptional results will see those results deteriorate in the future.
The same fundamental reversion is true for individual stocks. Graham was fond of saying that there is continuity to business. A solid business faced with some bad news or a falling stock price will move back toward fair value an overwhelming majority of the time. Just as a company sailing well beyond its fair value, will usually fall back to earth.
Graham’s teachings maintain their relevance because human nature has not changed. People still bid up stock prices to excessive levels and sink stocks well below fair value. It is just as hard to predict future market behavior today as it was in Graham’s day, but investors still try and ground their investments on extrapolating trends. And, of course, investors still pay top dollar for any future the market currently loves, instead of seeking strong margins of safety and buying stocks below their fair value.