A Conversation with Benjamin Graham

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
berntson
Posts: 1366
Joined: Mon Oct 29, 2012 12:10 pm

A Conversation with Benjamin Graham

Post by berntson »

I've been have great fun recently reading Benjamin Graham. I recently ran across this exceptionally interesting interview from 1976. I thought I would write up a post presenting what I think are some of the best highlights.

Graham thinks that it is futile for institutional investors to try to beat the market. He notes that if the average institutional investor were to beat the market, "that would mean that the stock market experts as a whole could beat themselves--a logical contradiction." As such, he thinks they should be content with market returns.

As has been widely notes, Graham suggests that he no longer thinks that individual investors should use the sort of security analysis that he pioneered to pick portfolios of individual stocks.
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. [emphasis added]
Here is the interesting part. Instead of suggesting that individual investors should buy index funds and accept market returns (as he does for institutional investors), Graham advocates two different strategies. The first strategy involves buying shares in companies that are selling below current net asset value. The second strategy is value tilting. I'll let Graham speak for himself here:
[The second strategy I advocate] consists of buying groups of stocks at less than their current or intrinsic value as indicated by one or more simple criteria. The criterion I prefer is seven times the reported earnings for the past 12 months. You can use others--such as a current dividend return above seven per cent or book value more than 120 percent of price, etc. [...] I have every confidence in the threefold merit of this general method based on (a) sound logic, (b) simplicity of application, and (c) an excellent supporting record. At bottom it is a technique by which true investors can exploit the recurrent excessive optimism and excessive apprehension of the speculative public.
Now we have a puzzle. Graham seems to endorse the efficient market hypothesis. He thinks that security analysis is not a worthwhile endeavor for the individual investor because there are too many smart analysts doing the same thing. But then he ends the interview by claiming that the true investor can "exploit the recurrent excessive optimism and excessive apprehension of the speculative public." That doesn't sound like something that an efficient market proponent would say!

Here is what I think Graham's view is, and it's a view that I rather like myself. The market price for a security can be thought of as its intrinsic value together with either a speculative discount or a speculative premium. Over time, the price of a security tends to converge towards its true value (i.e. there is reversion to the mean). Given the fierce competition when it comes to analyzing securities, it is nearly impossible to know whether or not a particular company is trading at a premium or a discount relative to its intrinsic value. But on the whole, by purchasing groups of stocks with low valuations, an investor increase her chances of buying securities selling at a discount.

Notice also that Graham doesn't think that the value premium is a risk premium. He thinks it has a behavioral explanation. Value investors outperform other investors because they are taking advantage of "excessive optimism and excessive apprehension of the speculative public." While this is a behavioral explanation, though, there is no particular reason to think that it will go away. Speculative excess will always be with us.

While he doesn't say it here, Graham's official view is that value investing reduces risk. This is because of the give more "margin for error." A growth stock with high valuations has to hit a home run just to be fairly valued. A value stock only needs a single.

In any case, the moral of the story is: You should read Benjamin Graham! He gives a fascinating perspective, from another era, on our own most pressing investment decisions.
Last edited by berntson on Tue Mar 04, 2014 9:17 pm, edited 2 times in total.
User avatar
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Re: A Conversation with Benjamin Graham

Post by LH »

nice post.
The Wizard
Posts: 13356
Joined: Tue Mar 23, 2010 1:45 pm
Location: Reading, MA

Re: A Conversation with Benjamin Graham

Post by The Wizard »

So basically, since 1976 then, we should pay a bit extra, if needed to buy value stocks or value funds then?
Because their expected payback is higher?
I think I'm starting to understand better now...
Attempted new signature...
terrabiped
Posts: 160
Joined: Mon Dec 30, 2013 2:29 pm

Re: A Conversation with Benjamin Graham

Post by terrabiped »

Turning now to individual investors, do you think that they are at a disadvantage compared with the institutions, because of the latter's huge resources, superior facilities for obtaining information, etc.?

On the contrary, the typical investor has a great advantage over the large institutions.

Why?

Chiefly because these institutions have a relatively small field of common stocks to choose from--say 300 to 400 huge corporations--and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor's Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list--say, 30 issues or more--that offer attractive buying opportunities.
Interesting. Sounds similar to AAII in that their whole focus is identifying what they call shadow stocks, that is companies that are too small for big dogs to invest in.


What general rules would you offer the individual investor for his investment policy over the years?

Let me suggest three such rules: (1) 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. (2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase--say 50 to 100 per cent--and a maximum holding period for this objective to be realized--say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market. (3) Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings.
That last bit sounds like valuation based asset allocation. I agree!
User avatar
stratton
Posts: 11083
Joined: Sun Mar 04, 2007 5:05 pm
Location: Puget Sound

Re: A Conversation with Benjamin Graham

Post by stratton »

There were no market cap weighted index funds in 1976 or Vanguard's fund was very tiny. The Wells Fargo equal weighted one might be in existence then, but probably wasn't accessible to your average person.

Paul
...and then Buffy staked Edward. The end.
grayfox
Posts: 5569
Joined: Sat Sep 15, 2007 4:30 am

Re: A Conversation with Benjamin Graham

Post by grayfox »

What general rules would you offer the individual investor for his investment policy over the years?

Let me suggest three such rules:

(1) 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.

(2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase--say 50 to 100 per cent--and a maximum holding period for this objective to be realized--say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market.

(3) Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings.
(2) This sounds like buy-low, sell-high strategy. Sell after gaining 50-100%. Sell out after 2-3 years if gained is not reached.

That is so old school. But who here invests that way? Even Ben Graham''s greatest student, Warren Buffet, says his favorite holding period is forever. This totally goes against the idea that stock returns have no predictability in the short term, but some predictability in the long term.

Does anyone advise investing that way today? As far as I understand, most of the Boglehead books recommend buy and holding at least until retirement when you start making withdrawals. Maybe some rebalancing along the way. But just keep adding to TSM or TSM/TISM. No selling out after 100% profit or 3 years.

:?: That article was from nearly 40 years ago. Ben Graham said his approach from 40 years prior was obsolete by 1976. Is the 1976 approach still a viable investing methodology in 2014?
User avatar
packer16
Posts: 1444
Joined: Sat Jan 04, 2014 2:28 pm

Re: A Conversation with Benjamin Graham

Post by packer16 »

I invest that way but only as an enterprising investor not as a defensive investor as many/most are here. I usually set an upside price based upon valuation and buy when there is at least 100% upside sell at a min of 50% upside and swap at a ratio of 2x upside of sell to buy. I also use the time frame to get a rough idea if the mispricing is a true discount due or a lack of underlying business value. I think the advent of low cost index funds with a value "tilt" that implement much of the strategy Ben Graham described would have led him to recommend these to most defensive or passive investors.

Packer
Buy cheap and something good might happen
Post Reply