By now we've all (should have) been to the Berkshire Hathaway site to read the various annual reports and letters to shareholders, and we all (should) have the Owner's Manual memorized. When Warren Buffett writes something, we should listen. After all, the tone of his writings have gone from serious and secret to educational and fun—the musings of a man likely sitting at his desk, typing letters, and laughing because everyone reads them but few follow his billion dollar advice.
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Graham and Dodd "look for values with a significant margin of safety relative to prices" approach to security analysis out of date?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 insure 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.
Buffett begins by examining a group "superinvestors"—but not in the traditional method of find-an-anomoly-and-backtest-and-publish; rather, he preselected these superinvestors more than fifteen years prior. His goal: Answer the above question, not just present one side or one approach to it.
The Graham, Dodd, & Buffett Zoo
Imagine that 225 million Americans joined a national coin flipping contest, each waging one dollar per flip. On one flip of the coin, those who call the flip correctly collect the dollar and advance to the next day. The losers drop out.
Each subsequent day, the stakes increase because the money pours over from day to day. According to Buffett's estimation, roughly 220,000 contestants would remain after ten flips on ten mornings—each waving won a little over $1,000.
Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.
Ten days later, only 215 people would have successfully called their coin flips 20 times in a row—each having turned $1 into $1 million.
But then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same—215 egotistical orangutans with 20 straight winning flips.
And Buffett debunks the professor—correct in theory, but wrong in practice:
For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he's feeding them, whether they had special exercises, what books they read, and who knows what else.
The Problem With Theory
Theories are great...on paper. In practice, it is a whole different ballgame. I'd be willing to bet my $1,000,000 rock that some brilliant statisticians have "cracked the markets"—have backtested a system that proves that the markets move on mathematical formulas or that it is possible (or impossible) to beat the markets.
In fact, I did it once. Using backtesting, I figured out a way to play the S&P 500 off the FTSE to "guarantee" a 0.5% return virtually every single day. Then, I ran that simulation (with play money) in real-time for six months. I lost my ass.
The article continues by presenting the audited histories of various superinvestors—all hailing from the then Graham-And-Dodd, now-Buffett school of investing. Walter J. Schloss—21.3% a year for 28+ years vs. 8.4% for the S&P; Tweedy, Brown, Inc.—20% for 15+ years vs. 7% for the S&P; Buffett—29.5% for 12+ years vs. 7.4% for the Dow; Sequoia Fund—18.2% for 14 years vs. 10% for the S&P.
The list goes on and on.
About Risk And Reward
I would like to say one important thing about risk and reward. 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!
While many advisers, news reporters, and Wall Street want you to believe that the same is true in the markets, I'm more inclined to believe Warren Buffett:
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.
Great In Theory, But In Practice?
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles for $8 million each. Since you don't have your hands on the $400 million, you want to be sure you are in with honest and reasonably competent people, but that's not a difficult job.
You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. 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.
Nice Article. But If Everyone Does It, Will The Strategy Still Work?
In conclusion, 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 value investing in the 35 years 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.