The Super Investors of Graham-and-Doddsville
by The Bayesian Observer
The Super Investors of Graham-and-Doddsville is neat little a 13-page article by Warren Buffet that appeared in 1984 in a Columbia Business School magazine. In it, Buffet talks about the value-investing method of his teachers Graham and Dodd of Columbia University.
Main takeaways from the article:
- Buffet argues that the Efficient Market Hypothesis is false.
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.”
- Graham made a distinction between investing and speculating:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
- The main tenet of Graham and Dodd’s school of investing is to look for inconsistencies between the current market price of a company and its true value. This requires analyzing a company’s balance sheet and activities in order to come up with a fair value. When the market price drops because of a silly reason, rather than a change in the company’s value, value investors argue that it will eventually rebound back. An example would be a company’s stock price nosediving if its CEO is found to be involved in a personal scandal and is about to be fired. When no value investing opportunities present themselves, value investors prefer to sit with cash and wait, rather than invest in risky investments.
- Value investors look for a margin of safety, that is a significant difference between the market price and the value.
… You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing
- Value investors wait for the right opportunity to invest in a security with a large margin of safety. In absence of such opportunities, they prefer to sit on cash. Mohnish Pabrai, another student of the Graham-and-Dodd school, says of Charlie Munger, also of the Graham-and-Dodd school, and Buffet’s partner at Berkshire Hathaway:
You have to be like a man standing with a spear next to a stream. Most of the time he’s doing nothing. When a fat juicy salmon swims by, the man spears it. Then he goes back to doing nothing. It may be six month before the next salmon goes by.
- Buffet argues that the value investing school of Graham and Dodd has produced a significantly large crop of disciples that have performed extremely well with that method, adding that this could not have been pure chance.
- Ridiculing complex mathematical models, Buffet has this to say about the practice of using multiple variables and seasonal trends in making ‘investment’ decisions:
I always find it extraordinary that so many studies are made of price and volume behavior, the stuff of chartists. Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before? Of course, the reason a lot of studies are made of these price and volume variables is that now, in the age of computers, there are almost endless data available about them. It isn’t necessarily because such studies have any utility; it’s simply that the data are there and academicians have worked hard to learn the mathematical skills needed to manipulate them. Once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail.
- Risk and reward are not always positive correlated, case in point being Value Investing, where risk and reward are negatively correlated. I thought this was a significant point — most discussions on investing implicitly assume that risk and reward are positively correlated.
Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, “I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.” I would decline — perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice — now that would be a positive correlation between risk and reward! The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
- It appears to me that ‘investors’ who are looking for a gain in a specified short time scale (say 1 month) are more constrained that those willing to wait longer (i.e. value investors). The comparison is akin to a company only looking to show great quarterly results, versus a company willing to spend on R&D that would mature only over the next 5-10 years. This line of thinking suggests that professional money managers (the majority of which are not value investors according to Buffet) are less consistent in their performance because they fall in the former category of firms, since they must show their performance quarterly, or annually. What if the pressure to post a performance number every quarter/year-end was absent?
- It struck me that it requires careful analysis of a company’s records and activities to figure out its fair value. If a significant fraction of users make investment decisions without making this analysis (Graham calls this speculation, as opposed to investment), this amounts to a larger amount of herd mentality in the market, and by Buffet’s own quote above, this would lead to deviations from the efficient markets hypothesis. In a sense, the success of value investing relies on others not being value investors. Addressing this thought, Buffet ends the article befittingly:
… some of the more commercially minded among you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. 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.
Now, all I need to do is figure out how to come up with the true value of a company.