Which value investment letter would Ben Graham follow today?
Imagine for a moment that you're on a cobble street in London late at night when, in true Mr. Bean fashion, a spotlight flickers on from somewhere overhead and a body falls from the sky. The man gets up, brushes off his impeccable three piece suit, and then makes his way over to you. It's Mr. Graham.
Before you have a chance to untie your tongue Ben smiles reaches out to shake your hand, and asks you which value investment letter to follow. What would you say?
Value investing has changed by leaps and bounds since Ben Graham first developed his strategy in the 1920s. As a young man, Ben made a name for himself by studying special situations and writing up recommendations in his own value investment letter.
But most value investors do not model their investing on how Graham started. Those who call themselves true followers of Ben Graham focus on implementing the techniques Graham published in his famous Security Analysis series.
It's easy to understand why. Graham's easily accessible work provides a very thorough discussion of both the principles and philosophy of value investing. While Warren Buffett has left a wealth of advice as part of his interviews, lectures, and shareholder letters, these are scant on detail compared to the ocean of practical advice that Ben Graham left behind in his writing.
But it doesn't make sense to follow information just because it's widely available; and, few investors realize that Graham significantly changed his approach to value investing just before his death in 1976. Any value investing letter Benjamin Graham would follow today would have to pay homage to where the great thinker ended up late in life. His later stance on value investing represents the sum total of a lifetime of practical experience and deep thought about the subject, after all.
It makes sense to listen to the master's advice later in life since it reflects the culmination of a lifetime of work and thought, right?
I agree - which is why I've incorporated it into my own investing as well as The Broken Leg's Value Investment Letter. For the full investment guide, click here. Most of this advice can be found in two key interviews Graham gave in his final years: The Simplest Way To Select Bargain Stocks, published in Medical Economics, and A Conversation With Benjamin Graham, published in the Financial Analysts Journal. These two articles are absolutely critical to understanding Graham's thoughts because they're the last interviews Graham gave.
Ben Graham's shift couldn't be more straight forward. In A Conversation With Benjamin Graham, he says:
“[I recommend] a highly simplified [strategy] that applies a single criteria or perhaps two criteria to the price [of a stock] 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.”
In other words, Graham recommended that investors focus on a couple solid value metrics to show that, on the surface, you're buying cheap stocks... and then diversifying heavily. Part of this means shifting your focus from the return of each and every stock to the return of the group.
But diversification was also a clear recommendation in Security Analysis... so what exactly did he change? Here's a hint:
“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.”
The major shift that Graham made was in the depth of the research he thought was required for solid stock selection. Where he recommended days of deep research into the firm's financial statements, management team, and qualitative situation of the company, Graham shifted to basing his stock picks off of simple value metrics.
In Medical Economics, when asked about how earnings growth or market share fit into the investment picture, he said:
"Those factors are significant in theory, but they turn out to be of little practical use in deciding what price to pay for particular stocks or when to sell [stocks]. The only thing you can be sure of is that there are times when large numbers of stocks are priced too high and other times when they're priced too low. My investigations have convinced me you can predetermine these logical "buy" and "sell" levels for a widely diversified portfolio without getting involved in weighing the fundamental factors affecting the prospects of specific companies or industries."
This is dramatically different than how a lot of investors invest. But, given that most investors earn terrible returns, don't you think it's time to heed the master's advice?
Any value investment letter Ben Graham would follow today would focus on simplicity.
Part of that simplicity means focusing on high performance no-brainer investment strategies.
There are all sorts of value investing strategies and some perform much better than others. Buying stocks at a low price to book value, for example, is a staple of academics who study investing. Despite how prevalent the low price to book strategy is, stock returns associated with typical low price to book stocks are only marginally impressive, often returning only a few percentage points per year over the market's return.
Most investors want to achieve the best long term returns possible so I'm puzzled why so many focus on lower return value strategies. Aside from missing out on the enormous returns offered by a select group of deep value strategies, employing a lower return strategy can significantly handicap an investor's ability to earn market beating returns at all.
This is because of a phenomenon known as "the behavioural gap". The behavioural gap is the underperformance an investor suffers relative to expected returns due to investor biases. As you try to implement an investment strategy, psychological biases enter your decision making process, causing you to make less than optimal decisions. Perhaps, hoping a stock price drops, you'd wait a week only to see the stock rise, for example. Other biases cause you to pass on perfectly good investments because of something you don't like about them.
Joel Greenblatt is supposed to have one of the best investing records of all time, yet even he falls victim to these errors. For instance, Greenblatt wrote about passing on a pharmaceutical company whose drugs were soon going off patent only to see the stock price rise dramatically after the firm was identified by his investment criteria. His error is what we now know as the broken leg problem, the tendency for us to exclude a stock from purchase for some reason that's actually irrelevant to whether the stock will work out as an investment or not.
Partially recognizing his own fallibility, Graham would opt for value investment letters that focused on high return value strategies. We mentioned low price to book value strategies before, but variants of this strategy exists which actually provide enormous returns for small investors. One of Graham's favourites was his net net stock strategy:
“…[this] 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.”
It's hard to argue with endorsements like that, which is why we incorporated net net stocks into The Broken Leg Investment Letter. For a full run-down of the highest performing deep value strategies, click here. So, when selecting a value investment letter for yourself, remember...
Ben Graham would make sure his chosen value investment letter focused on high performance value investing strategies.
When I first started value investing, I tried to identify strategies that were both backed by academic studies and significant returns achieved with real money in the real world. It's one thing to cherry pick numbers from a computer simulation, and quite another to identify an actual viable investment strategy.
A lot of investors know that Graham followed some great investment strategies but few realize how intensely Graham tested his strategies before putting money to work. Right before his death in 1976, Graham was excited about a strategy that he'd tested over a 50 year period and planned to start using it with a new partner. The strategy later became known as Graham's Simple Way:
"...in the long run, you should average a of 15 percent a year or better on your total investment, plus dividends and minus commissions. Over all, dividends should amount to more than commissions."
We've followed Graham's lead by demanding significant academic or industry studies to help identify winning strategies. But, unlike Graham, we also look for evidence of successful use in practice before we adopt a strategy for our value investment letter.
Take our Ultra strategy for example. Studies have shown that firms trading at incredibly cheap prices relative to net assets produce some of the highest returns available - near 30% on average per year. This is why we've adopted it for our value investment letter. Walter Schloss also favoured these sort of stocks:
“…those companies with large book values in relation to market prices offer the stock holder the greatest rewards…”
Schloss moved to ultra low price to book stocks when he couldn't find net nets to buy. We're more demanding in our criteria, however, eliminating intangible assets and requiring either insider buys or share buybacks.
Likewise, we built on Graham's original Simple Way strategy after extensive backtests. Given Graham's 50 year study, we thought his Simple Way strategy had an excellent base to build on for our value investment letter. We started with his original criteria but then added a low price to book value and a high dividend yield requirement which boosted performance up to roughly 24% per year since 1999.
When looking for a value investment letter, Ben Graham would focus on proven value investment strategies.
Graham was all to aware of the enormous psychological pressure that investors feel when investing, over and on top of investor biases. When stock markets rise, for example, investors feel the urge to abandon rigorous safety standards and buy hot stocks that they think will surge. When markets drop, on the other hand, investors feel an enormous urge to sell their positions and get out of the market to reduce the pain they feel and prevent further damage. This pressure can completely derail your future success.
Some value investors today employ checklists to help automate their decision making and sidestep these issues. They're called Mechanical Value Investors and it's clear that Ben Graham was moving in this direction late in life. He advised inA Conversation With Benjamin Graham:
“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.”
The words we're more concerned with here are "he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning". It's hard to make impersonal objective decisions if you're making decisions on the fly. When you need to make sudden decisions based on the information in front of you, all sorts of biases and emotions start to enter the decision making process.
A checklist, or scorecard, on the other hand, is a list of criteria and rules that you use to evaluate an individual stock investment. An intelligent investor would spend a significant amount of time thinking about criteria and backtesting to arrive at a solid mix before attempting to make an investment decision. Creating the criteria before attempting to make an investment allows the investor to "stay rational" to a much greater degree and results in better investment decisions.
Today, Graham would look for a value investment letter that employed a solid scorecard.
One of the most challenging areas of investment is, ironically, not which stocks to buy but when to sell. In fact, despite how often Ben Graham discussed the need for smart portfolio management, few investors focus on this aspect of investing.
That's a shame because, in my experience, portfolio management is one of the most critical areas to get right. Make a few big mistakes when it comes to putting together a solid portfolio and you can easily see the returns available to your chosen strategy wither up. Even worse, poor performance due to terrible portfolio strategy can turn you off of what would otherwise have been an exceptional long term strategy.
The first aspect to get right is where cash fits into your portfolio. Professional investors talk about the need to have a good portion of your portfolio in cash - but it's important to remember that professional investors are handcuffed by restraints that you don't have to deal with. First, pros suffer withdraws during bear markets so have to liquidate positions to provide fund investors with an ability to exit the fund. This means selling cheap stocks at ridiculous prices if you don't have cash in hand.
The vast size of the funds pros have to manage also dramatically reduces the number of quality opportunities available. Large investors are not as flexible as small investors when it comes to being able to pick up stocks - small investors can buy tiny companies and therefore have infinitely more opportunities. For small investors, there should always be something to buy.
Professional investors, in contrast, can often only pick from the 500 largest firms available in the market. Since most fund managers are concentrated on the largest companies, there is a lot of competition and opportunities are scarce. This is also the major disadvantage of most value investment letters.
Remember Buffett Superinvestor firm Tweedy, Browne? They earned one of the best track records of any investment company, anywhere. You can bet that they know a thing or two about investing. When it comes to holding cash, this is what they had to say:
"It is a little painful for us to write this section because, in our past, we often sat on our thumbs with too much cash in clients’ portfolios before empirical research and our own analysis convinced us of the error of our ways. We were not knowingly market-timing, but were over-diversifying: Instead of investing 3% of portfolios in a perfectly good bargain stock, we invested 1% because we wanted to buy more at even lower prices. Cash, and lower investment returns, were the residual of this process. Over the last 22 years, the after-fee return on the portion of our clients’ portfolios invested only in stocks (not cash), 21.4%, beat the return on cash, 7.1%, by 14.3% per year."
You have to commend Tweedy, Browne for their honesty. Few people can openly and publicly admit their screw ups like this. You now have to chance to avoid falling into the same trap so, as Tweedy, Browne says, stay as fully invested as possible.
Once you have this concept in place, the question is how many stocks to hold in your portfolio. The master, Ben Graham, recommended holding about 30 stocks when using a simple mechanical value investing strategy. We agree on the need for solid diversification, but we also look for exceptional value stocks. Once we identify a possible investment candidate, we look for positive indicators that are associated with higher returns and a better win rate.
For example, we love to buy dirt cheap stocks relative to net tangible assets. Once we find one of these stocks, we look for insider buys and share buybacks which are both associated with higher returns for Ultra stocks as a group. These two factors also boost the number of winning stocks we pick.
Because we focus on exceptional deep value stock opportunities, we concentrate a little more and suggest that investors hold 20 to 24 stocks in their portfolio in our value investment letter.
Finally, as mentioned at the start, knowing when to sell is crucial for solid portfolio management. According to Graham:
"The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques."
Following Graham's advice, we adopt a solid mechanical sell strategy so that investors know exactly when to sell a stock. This is the same approach that I've used for my own portfolio, and it's worked out tremendously well.
When selecting a value investment letter, Ben Graham would ensure that it followed a solid portfolio management strategy.
Ben Graham was the master of value investing and shared a lot of his knowledge with small private investors - so it makes sense to follow his advice, right?
Despite the tremendous body knowledge that he published throughout his life, Graham's thoughts on investing shifted a lot. While a lot of investors focus on Security Analysis, these books represent the thoughts of the man during mid-life. We prefer to focus on the conclusions Graham came to in the mid-1970s which reflected the culmination of everything he learned as an investor.
It's clear what Ben Graham would look for in an exceptional value investment letter and investors should do the same. In our view, a value investment letter has to have:
Simplicity of process & approach
The highest possible value strategies
Value strategies proven in studies and real world practice
A rigorous scorecard to use for stock selection
And a solid portfolio management strategy
...to give investors the best chance of achieving great returns. It's not surprising that we've incorporated all of these techniques into The Broken Leg Value Investment Letter.
Click here to sign up for The Broken Leg Investment Letter right now because you do not want to waste another year earning mediocre returns.