Benjamin Graham was the father of security analysis and the intellectual Dean of Wall Street. I believe Graham was many things, including the father of the many ratios we take for granted in our work as analysts, portfolio managers and investment officers. Perhaps controversially, I also believe he may not have reached some of his conclusions had he access to a computer that allowed him to properly test his ideas.
Having said that, there are many things that Ben said that not only made sense but made significant contributions to investment thinking. And despite the absence of a computer, Graham observed several characteristics of the market that the advent of modern computing has only served to reinforce.
For those grateful for executive summaries, here follows mine on the three most significant contributions Ben Graham made to the body of work on investing.
By understanding, testing and implementing the approaches that flow from a study of Graham’s principles, I believe any investor will benefit not only in terms of returns but also in terms of risk mitigation. In Part 2 next week, we will display anecdotal evidence of their truth with graphics using modern computing and the techniques of the development team at Skaffold.com.
Lesson One
The first of Graham’s significant contributions is his Mr. Market allegory, introduced in 1949. Mr. Market is of course a fictitious character, created to demonstrate the bipolar nature of the market.
Here is an excerpt from a speech made by Warren Buffett about Ben Graham on the subject:
“You should imagine market quotations as coming from a remarkably accommodating fellow named Mr Market who is your partner in a private business. Without fail, Mr Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains…
Mr Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow.
Transactions are strictly at your option…But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr Market is there to serve you, not to guide you.
It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”
The implications of this little story cannot be understated. What Graham is saying is that there is a legitimate alternative to the Efficient Market Theory as a model of the way the market behaves and works. He said this before EMT became the cornerstone of every financial services firm that cared about “biggering and biggering and BIGGERING.”
Another significant implication is that as investors we should be less focused on price as our guide as we should on value. This challenges the validity of many streams of financial study that have as their root, the price of securities. Think about all the PHD papers and other academic studies that uncover relationships, or validate the power of explanatory variables, but whose concluding evidences are merely price, or some derivative of price. If prices in the short run are determined by those who are merely selling to renovate the bathroom or by events in Syria – events that have no impact on the number of $2 buckets being sold by The Reject Shop – what ‘value’ can we place on them?
Lesson Two
The second great lesson Ben Graham taught gave us the three most important words in value investing; margin of safety. In engineering the margin of safety is the strength of the material minus the anticipated stress. Building materials that are far stronger than that required to survive the anticipated stress ensures a degree of comfort.
When it comes to investing, the margin of safety is the estimated value of a share minus the price. The greater the margin of safety, the greater the degree of comfort and more importantly, the greater the expected return. If the price is what we pay, and the value what we receive, then the lower the price we pay, the higher the return.
Lesson Three
Despite the high profile of these enduring two lessons, I believe there is a third observation of Graham’s, which is equally important. Fascinatingly, with the benefit of computers, we can also demonstrate that Graham was spot on.
Graham was paraphrased by Buffett in 1993:
“In the short run the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long run, the market is a weighing machine.”
What Graham described is something that, as both a private and professional investor, I have observed myself; in the short term, the market is a popularity contest – prices often diverge significantly from that which is justified by the economic performance of the business. But in the long term, prices eventually converge with intrinsic values, which themselves follow business performance.
Next week, we will compare intrinsic value and share prices for some major Australian stocks to illustrate Ben Graham’s enduring principles.
Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund.