In the preface to the Sixth Edition of Graham and Dodd’s Security Analysis, Seth Klarman says the following:
On what is value investing:
- “Value investing, today as in the era of Graham and Dodd, is the practice of purchasing securities or assets for less than they are worth - the proverbial dollar for 50 cents. Investing in bargain-priced securities provides a “margin of safety” - room for error, imprecision, bad luck, or the vicissitudes of the economy and stocks market.”
“Value investors demonstrate their risk aversion by striving to avoid loss.”
- “…the Efficient Market Hypothesis (EMH), holds that security prices always and immediately reflect all available information, an idea deeply at odds with Graham and Dodd’s notion that there is great value to fundamental security analysis. The Capital Asset Pricing Model (CAPM) relates risk to return but always mistakes volatility for risk. Modern Portfolio Theory (MPT) applauds the benefits of diversification in constructing an optimal portfolio. But by insisting that higher expected return comes only with greater risk, MPT effectively repudiates the entire value-investing philosophy and its long-term record of risk-adjusted investment out-performance. Value investors have no time for these theories and generally ignores them.”
“…Academics and many professional investors have come to define risk in terms of the Greek letter beta, which they use as a measure of past share price volatility: a historically more volatile stock is seen as riskier. But value investors, who are inclined to think about risk as the probability and amount of potential loss, find such reasoning absurd. In fact, a volatile stock may become deeply undervalued, rendering it a very low risk investment.”
1. At the individual security level – I tend to agree with Klarman’s view. Value investing is ‘buying dollars for fifty cents”. There are (some) inefficiencies in individual security pricing that can result in these ‘bargain’s. However three points:
- (i) It’s very difficult to identify these bargain securities: as Swensen says (in Pioneering Portfolio Management): “Investors willing to implement value-based oriented programs require unusual skill, intelligence and energy. Without a significant edge relative to market participants, investors face likely failure."
(ii) There are relatively few opportunities: many successful value investors (e.g. Klarman, Greenberg) hold concentrated portfolios (few holdings), and
(iii) Holding on to these securities requires significant patience, and courage of conviction - attributes that relatively few possess. Glenn Greenberg summarizes this well in the Sixth Edition of Security Analysis: “If Graham and Dodd are so widely read and respected, why are there so few disciplined practitioners of their advice? I believe the answer lies in three human traits: aversions to boredom, a tendency for emotions to overwhelm reasons, and greed”. ….. “If it all seems self-evident, like Polonius’s speech, that’s because such wisdom has stood the test of time and it has become part of our lexicon as investors. Yet few people endeavor to walk the walk be researching businesses intensively, sifting through many dozens to find those worthy of capital. Few people are willing to concentrate their investments in a small number of businesses that they know thoroughly and believe will grow their net worth at an attractive rate over the long-term. Many days this work is just plain boring. Other days (and sometimes months), the market totally ignores your handful of precious stocks. A portfolio of predictable, reliable businesses does not make you the most exiting person at the cocktail party, nor does it give you flashy sales promotion material. I have come to believe the quest for rational investing is appealing only to a handful of us. But at least we sleep well at night and live well by day – and our clients do as well.”
Is it possible to identify good “dollar for fifty cents” managers? Difficult to do IMO. Here are three who try to practice the Graham and Dodd approach to value investing:
- 1. Fairholme: Discussed before. In addition Berkowitz was the only mutual fund manager included as a commentator in the Sixth Edition of Graham and Dodd’s Security Analysis. IMO of all the commentators his section was the easiest to understand – simply, clear, and relatively convincing. Berkowitz also emphasizes the ‘don’t lose’ philosophy.
2. Longleaf: Discussed in Swensen’s book. From their website “A company's market price generally must be 60% or less of our appraisal to qualify for investment.” (so a dollar for 60 cents approach). “We hold concentrated portfolios for two main reasons. Concentration lowers our risk of losing capital because we limit the portfolios to our very best ideas, and we know the companies we own and their managements extremely well.”
3. First Eagle: Bruce Greenwald was also included as a commentator in the Sixth Edition of Security Analysis (not a mutual fund manager but is the research director at First Eagle). From their website “Our insistence on a substantial margin of safety, healthy balance sheets and clear business models enables the avoidance of risk and the allowance to generate positive absolute returns over time.”…”loyal followers of Ben Graham”.