Modern and Timeless Graham

I attended a seminar last week that was labeled: “educational.”  It had been sponsored by one of the largest financial holding companies in the world.  Various individuals from the financial services industry were in attendance to hear an expert, who happens to run a new mutual fund, discuss his views on the American economy and emerging markets.  He was introduced after an active discussion on the need to, “find a better way,” in light of the NASDAQ Composite Index’s fall in 2000.  This individual was introduced with the following remarks: 

“I could not tell an 87 year old grandmother to buy and hold for the long term when she’s losing money in the market.  If she lived on $15,000 per year starting in 2000, the market swings guarantee that she would have lost all her savings in six years.  All she had was $300,000 to start with, and she said she won’t be around to wait for the market to go up in 25 years. There has to be a better way!” 

The answer is Active Management:  Let’s use demographic numbers and economic statistics to predict and identify market trends.  Then we actively manage our client’s assets by buying and selling into the trends, thus gaining whichever way the market swings.  Even our aging grandmothers can make money!

That is an amazing sales pitch!  In blissful financial ignorance I almost signed up to toss my savings off the nearest money cliff.  But before the gaggle of attorneys lines up to sue the financial services firm for not listening to the grandmother’s financial objectives, let’s listen to how persuasive the sell is. 

When the speaker came on stage he introduced some flashy facts to engage the audience.  “In 2010 there will be more fluent English speakers living in China than in the United States.” He used this fact to justify investing with the trend in Asia and not against it.”  Accordingly, his active management style is superior to the, “buy and hold method,” since buying and selling into obvious and blatant trends is more likely to yield out-sized returns.  Whilst often quoting Warren Buffet to give his comments some authority on the recession in America, he discussed the benefits of investing and finding value in trends.  In this respect, his words stood in stark contrast to what we heard at the Berkshire Hathaway Annual Shareholders Meeting.

Intrigued, I decided to do some more reading on his web site, which stated that his management style was modeled after “relative strength” analysis.   This fund manager advocates allocating your assets the same way you coach a football team.  Economic and investment trends help you determine when to play offense or defense.  In other words, you bring out your defensive investments when the markets are against you.  When it’s time to go on the offensive, you buy aggressively into growth stocks.  Today he advocates the offensive strategy of buying gold and oil. 

Statistics spat out by a computer scientifically verify his views on the economy.  After all, the numbers will never lie to you.  And neither will your astrologist or your numerologist. Only this time you get hit with a hefty 2.2% management fee for a fortune telling that likely hurts your fortune!

Ouch!

Now for those of you who follow the Oracle in Omaha instead, Warren Buffet has always emphasized, “Our favorite holding period at Berkshire is forever.”  In contrast to the speaker, Buffet is one of the most outspoken advocates of the buy and hold method!

How would a real value investor view this?  Charlie Munger, his business partner, would probably say, “It’s pure rat poison.” 

This is how Warren Buffet contrasts “buy and hold” investors to “active investors” in his recent letter to shareholders dated February 2008… 

“Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.” 

So it looks as if The Oracle does not advocate active management for most people. But why is that? The speaker likened our current economic condition to the stagflation we experienced in the late 70’s.  According to graphs used to introduce him, real growth only occurred from 1980 to 2000 followed by a “bear market”, the one we are supposedly in today with zero growth.  Thus the logic follows that you should utilize active management to see the gains similar to the ones you saw prior to the year 2000.

“No!” cautions The Oracle.  Instead of following the numerologist and the astrologer, we should gain wisdom by reading the prophecies of Warren Buffet as he shares his vision of the future with us.   Heed his warnings of false prophets and their promises of double digit returns…. 

“I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.” 

So taking the facts and putting them together, it seems that it’s quite possible that some people do live in fantasy land while dreaming up financial products.  They charge high fees to ignorant investors who have stars in their eyes.

 How far back does this silliness go?

One way to find out is to read from the original text of The Intelligent Investor, authored by The Oracle’s mentor, Benjamin Graham.   He offers up some sage advice in Chapter III of the 1949 edition.

“If the reason people invest is to make money, then in seeking advice they are asking others to tell them how to make money.  That idea has some element of naiveté.  Businessmen seek professional advice on various elements of their businesses, but they do not expect to be told how to make a profit.  That is their own bailiwick.” 

Graham points out that, “Because Wall Street has thrived mainly on speculation, and because stock-market speculators as a class are almost certain to lose money, it has been logically impossible for brokerage houses to operate on a thoroughly professional basis.  To do that would require them to direct their efforts toward reducing rather than increasing their business.”

“Since the most profitable customers want speculative advice and “suggestions,” the thinking and activities of the typical firm are pretty closely geared to day-to-day trading in the market.  Thus it tries hard to help its customers make money in a field where they are condemned almost by mathematical law to lose.”

Ben Graham concludes… “Most security buyers obtain advice without paying for it specifically.  It stands to reason, therefore, that in the majority of cases they are not entitled to and should not expect better than average results.  They should be wary of all persons, whether customer’ brokers or security salesmen, who promise spectacular income or profits.  This applies to the selection of securities and to guidance in the elusive art of trading the market.”

How might Ben Graham view this market? Is the buy at a reasonable price and hold method still a good one?  Can value investors that buy and hold, still outpace the post 2000 market?

If the speaker is correct, and we are in an age of volatility in the midst of 1970’s like stagflation, then assets should be difficult for institutions to value.  By extension, so should future earnings.  If future earnings are difficult to value then the markets will over react like they just did.  It’s during this time of over reacting that individual investors, unlike institutional ones, have the best opportunities to find value in businesses within their circle of competence.  Is it smart to go with the trend?  Instead stick with Graham!  If one sticks with the Graham – Dodd approach to valuing companies, like Buffet says to do, within one’s circle of competence, then the likelihood of finding a good value will significantly increase.

It’s telling that nothing seems to have changed since Benjamin Graham and David Dodd wrote Security Analysis in 1934, and Benjamin Graham wrote The Intelligent Investor in 1949.  If we go back even further to 1848 we can reference Baron d Rothschild.  He received a cable while in London from is staff in Paris.  Soldiers were fighting nearby, and the prices of government bonds had fallen to one quarter their market value.  His response… “I will not buy until the streets of Paris run red with blood!”  Taken in historical context, it’s at least comforting for the rest of us to know that Warren Buffet and Charlie Munger can find value for Berkshire Hathaway without having to go to such an extreme.  And at the same time, it’s comforting to know that some investment ideas have timeless value.  


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3 responses to “Modern and Timeless Graham”

  1. Andrew in Doddsville Avatar
    Andrew in Doddsville

    This article only serves to highlight that true investing is not “age” driven. One is either investing intelligently or speculating.

    I would encourage my fellow value investors to read “Fooled by Randomness” and “The Black Swan,” both by Nassim Nicholas Taleb, which describe, among other things, the inherent unreliability of most “predictive” methodologies.

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