The Superinvestors of Graham and Doddsville: Was Buffett Wrong?

This article on the superinvestors of Graham and Doddsville was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by jeonsango, edited by Broken Leg Investing.

The Superinvestors of Graham and Doddsville vs. The EMH

Do you believe that markets are efficient?

If so, you are not alone. In fact, some of the smartest finance professors in the world would agree with you. They believe that we, rational human beings, would never allow financial market mispricings to occur. Therefore, all securities are always reflective of fair value.

However, there are many – albeit fewer than those in the Efficient Markets camp– out there that would be inclined to disagree with you and those enlightened professors. They would tell you that humans are not, and never have been, rational beings.

Warren Buffett is one of those people. In fact, he feels so strongly about the topic that he wrote an article – The Superinvestors of Graham and Doddsville – that slated the very idea of The Efficient Markets Hypothesis (EMH).

So, who is right? Should we bother with investment analysis at all, or should we simply buy a share in an ETF and let the markets run their course?

Whatever you believe, Buffett’s opinion is always worth hearing.

“Is the Graham and Dodd ‘look for values with a significant margin of safety relative to prices’ approach to security analysis out of date? Many of the professors who write textbooks today say yes. They argue that the stock market is efficient; that is, that stock prices reflect everything that is known about a company’s prospects and about the state of the economy. There are no undervalued stocks, these theorists argue, because there are smart security analysts who utilize all available information to ensure unfailingly appropriate prices. Investors who seem to beat the market year after year are just lucky. ‘If prices fully reflect available information, this sort of investment adeptness is ruled out,’ writes one of today’s textbook authors."

"Well, maybe. But I want to present to you a group of investors who have, year in and year out, beaten the Standard & Poor’s 500 stock index. The hypothesis that they do this by pure chance is at least worth examining. Crucial to this examination is the fact that these winners were all well known to me and pre-identified as superior investors, the most recent identification occurring over fifteen years ago. Absent this condition — that is, if I had just recently searched among thousands of records to select a few names for you this morning — I would advise you to stop reading right here. I should add that all of these records have been audited. And I should further add that I have known many of those who have invested with these managers, and the checks received by those participants over the years have matched the stated records.”

Buffett is referring to the aforementioned hypothesis known as the Efficient Markets Hypothesis (EMH). The theory states that, in a world of increasingly improving technology and communication resources, the financial markets at all times reflect the most up-to-date information. The idea is that by the time any news of any particular market or company reaches a retail or institutional investor, its price has already changed. Therefore, it is an impossible task to outperform a market that already reflects perfect information. In short, the role of equity analysis is pointless, and fund managers (maybe even the superinvestors of Graham and Doddsville) should just pack their bags and find an alternative vocation!

The EMH predicts that it is impossible for any specific person, or group of people, to outperform the market on a consistent basis. The origins of the theory go back as far as 1900, but since then it has become one of the cornerstones of finance and economics academic teachings – I was taught about the EMH during both my undergraduate (Business and Economics) and Masters (Finance) studies! While Buffett clearly doesn’t believe in its existence, surely the majority of finance academia can’t be wrong on this?

The Superinvestors of Graham and Doddsville – A Product of Fate or Chance?

Buffett argues his case in the simplest of fashions – a coin flip.

“Before we begin this examination, I would like you to imagine a national coin-flipping contest. Let’s assume we get 225 million Americans up tomorrow morning and we ask them all to wager a dollar. They go out in the morning at sunrise, and they all call the flip of a coin. If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row. They each will have won a little over $1,000… Assuming that the winners are getting the appropriate rewards from the losers, in another ten days we will have 215 people who have successfully called their coin flips 20 times in a row and who, by this exercise, each have turned one dollar into a little over $1 million. $225 million would have been lost, $225 million would have been won. By then, this group will really lose their heads. They will probably write books on ‘How I turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning.’ Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, ‘If it can’t be done, why are there 215 of us?’”

Luck. Chance. Good Fortune. Whatever you call it, most will agree that there are people out there who seem to always have the coin flip in their favour. Whether it’s by turning up at the right place at the right time, happening to hold the winning lottery ticket, or anything in between, some people are just lucky.

In fact, that is also exactly what the EMH predicts; since there is apparently no level of skill or intelligence involved in choosing the right investment over the wrong one, the performance of any one fund is completely random. The idea is that all stocks are on a random walk and, because all public and private information is already baked into its intrinsic value, it is entirely impossible to predict any future movements in the stock.

This, of course, also means that if one fund manager were to experience superior returns over others, on a consistent basis, that person could and should only be regarded as lucky – or at best, experiencing good karma!

While Buffett is clearly steadfast in his belief, does it not seem at all possible that the existence of the superinvestors of Graham and Doddsvillle – the supposed highly skilled investing outperformers – might also be a product of chance? What if these men are simply just the lucky few who made it through the right side of 20 consecutive coin flips?

The Superinvestors of Graham and Doddsville – Does Correlation Prove Causation?

Warren Buffett is clearly not much of a fan of the EMH. However, it’s going to take some convincing now for us to think that the performance of the superinvestors of Graham and Doddsville is a product of anything other than dumb luck. After all, as it is the Warren Buffett that we are talking about here, let’s give him a shot.

“In this group of successful investors that I want to consider, there has been a common intellectual patriarch, Ben Graham. But the children who left the house of this intellectual patriarch have called their ‘flips’ in very different ways. They have gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply cannot be explained by random chance. It certainly cannot be explained by the fact that they are all calling flips identically because a leader is signaling the calls for them to make. The patriarch has merely set forth the intellectual theory for making coin-calling decisions, but each student has decided on his own manner of applying the theory. I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”

What we see here is about as close to a literary home run as you can get. How can one argue that a group of individuals’ performances is down to chance, when the very same – and yet, very different – individuals all have something in common? If the individuals all learned their investing principles from the same man, but utilised them in a massively diverse set of ways, it is extremely hard for even the most hardcore EMH fanatic to argue that their beloved hypothesis was at play here.

So, now that we know that the EMH is false, the question becomes, why have academics not ceded to Buffett? Why is the EMH still going strong when it comes to academia? Why was I still being taught about this topic by professors who are much smarter than I as recently as 2016?

How can anyone justify the invalidity of the Superinvestors of Graham and Doddsville and their value-oriented approach to investing?

If the answer to the question of whether or not the EMH is real – and therefore, whether value investing is an appropriate strategy – is so simple, then why is everyone not adopting this approach?!?

“I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”

Like the great Buffett himself says, value investing is not a new idea. The truth of its success has been public information for years, yet the number of people who adopt the strategy remains small. The reason for this might be its counterintuitive nature. Alternatively, and as Buffett suggests, it might appear too easy and therefore seem too good to be true. Whatever the reason for the underutilisation by people of value investing strategies, it provides even more potential opportunities to those of us who have been captivated by its power.

Armed with this newfound knowledge, and whatever your opinion on the teachings of finance academics, allow yourself to take advantage of an investing philosophy that the world continues to ignore. Who knows, you could end up with a record just as impressive as the superinvestors of Graham and Doddsville!

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