Channeling Graham and Dodd: A Conversation with Seth Klarman

by: Value Investor Insight

Early in the process of defining how to update Graham and Dodd’s Security Analysis, the acknowledged “bible of value investing,” lead editor Seth Klarman and his assembled team abandoned any notion of editing the text of 1940’s second edition. “It would have taken a decade to rewrite, with absolutely no assurance we could have improved upon it anyway,” he says.

Instead, Klarman assembled a who’s who of prominent value investors – including Glenn Greenberg, David Abrams, Howard Marks and Thomas Russo – to write introductory commentary to each of the book’s sections, drawing out the timeless wisdom in the original text and combining it with additional insight and examples relevant to today’s market.

In the September 30 edition of  Value Investor Insight, Klarman described this process. Key excerpts follow:

Why take on what was surely a time-consuming role with this book?

Seth Klarman: First of all, it was an honor to be asked and I don’t think one says “no” lightly to something like that. But on top of that, I feel a huge amount of loyalty to Graham and Dodd. Their thinking has influenced mine right from the beginning, so what could be more of an honor – and more of a responsibility – than to contribute to updating their work?

What tenets of Graham and Dodd have most influenced you as an investor?

SK: I think Graham and Dodd’s writing is not actually about investing, but about thinking about investing. Any book can say, “Buy stocks that fit the following criteria,” but Graham and Dodd go beyond that to fully explain why. It’s like the difference between being able to divide two numbers using a calculator and actually knowing long division. A Graham and Dodd investor understands both the numbers and the concepts behind the numbers. In a world in which most investors appear interested in figuring out how to make money every second and chase the idea du jour, there’s also something validating about the message that it’s okay to do nothing and wait for opportunities to present themselves or to pay off. That’s lonely and contrary a lot of the time, but reminding yourself that that’s what it takes is quite helpful.

Warren Buffett is right when he says you should invest as if the market is going to be closed for the next five years. That’s particularly relevant right now – who knows, that might be the next thing the government does! The fundamental principles of value investing, if they make sense to you, can allow you to survive and prosper when everyone else is rudderless. We have a proven map with which to navigate. It sounds kind of crazy, but in times of turmoil in the market, I’ve felt a sort of serenity in knowing that if I’ve checked and re-checked my work, one plus one still equals two regardless of where a stock trades right after I buy it.

In your essay for the book you describe how the breadth of information available to investors has eroded one of the biggest market inefficiencies out there – namely, access to the best information. How can investors respond to that?

SK: Some people’s way of dealing with a market in which information is more available and ubiquitous is to try to get better and better information. That’s driving the growth in services providing broad access to industry experts or the hiring by money managers of lawyers and other specialists to address company- and industry-specific questions. That’s not necessarily our approach at Baupost, because one of the things we worry about like crazy is when information is what I would consider unacceptably clever and comes too close to crossing an ethical or legal line.

An alternative way of dealing with information being more available is to stop playing the game and seek out securities or asset classes where there’s less information or competition. Many firms have realized over the last ten years that it’s harder to add value in equities.

Is that a permanent condition?

SK: I would actually stipulate that this might be about to change because of the way markets are evolving. You could argue that for the past 10 or even 20 years, equities haven’t been allowed to get cheap. When it appeared the market was really going down – in 1987, 1998, 2000 – the government tended to intervene to prop it up. One of the pernicious problems of doing that when things are about to get cheap is that it creates the illusion that there isn’t much downside risk, and also prevents the necessary creative destruction that happens when an asset gets incredibly cheap. When assets get cheap, people stop manufacturing it because you can buy the used ones cheaper. That’s a healthy constraint on the market and gluts are prevented.

With leverage being ever more available and the government not desiring the market to go down, that sowed the seeds for today’s set of problems. It was as if risk wasn’t out there, leading people to write ridiculous books about the Dow going to 36,000 as risk premiums went to zero. It changed financial institutions’ behavior toward leverage, which in any number of ways has proven to be ruinous to many of those institutions. People say that what has happened recently was completely unpredictable and a god knows how many sigma event, but that’s just not right. This was completely predictable and I could cite eight or ten people who in one way or another predicted it.

The result of risk being ignored was that everybody on the buy side started effectively using an LBO model, trading securities on some invisible grid, so that when a stock became the slightest bit inexpensive because the company missed earnings or something, the wise guys stepped in to buy because its buyout price in an LBO was higher. With nothing getting very cheap, it became very hard to add value with securities selection. In the past fifteen months we’ve seen a complete breakdown of the private-equity model – since there is no available leverage – and we’re starting to see stocks trade at whatever price. There’s a much higher probability that fundamental value investors in this type of period will be able to add value with specific stock selection.

Has the federal intervention of the past two weeks changed your view on that?

SK: It just points to the fact that a paint-by-numbers value-investing approach probably isn’t good enough anymore.

For the first time since the 1930s, when Graham and Dodd first wrote Security Analysis, we’re seeing the government intervene in an unimaginably large way in our markets and our lives. That has changed the rules in the financial sector, maybe for a year or two, maybe for good. We’re facing the possibility, at least, of a rather severe economic downturn and who knows what else. That makes it a tough time for all investors, and it’s more necessary than usual to have a view on the economy, on global markets, on debt markets, on derivative markets, on securitization markets. If you didn’t see what other markets than the equity market were saying about the value of subprime mortgages and what they were implying about home-price depreciation, the traditional value investor might have been tempted by financials even a year ago. Having insight into only one market is likely not going to be sufficient.

You criticized in the book the “frenetic lunacy” of cable-television coverage of the stock market. How important has that been in the booms and busts we’ve been seeing?

SK: You can’t blame the media for the subprime crisis or the out-of-control securitization that led to the financial crisis. What the media should be criticized for is the “cheerleader” aspect to its coverage. Champagne corks would pop with every new 1,000 points on the Dow, as if that was the natural state of things and that imagining that it could go down – or even rooting for it to go down – was un-American. It’s gotten better when you start to see people like Warren Buffett show up more on channels like CNBC, but I still find financial news as entertainment, with someone like Jim Cramer, sort of sad.

Coverage of the market is always about making money, when in fact sometimes you should be worried about preserving your money. Since you don’t get advance warning about what kind of environment is coming next, you should always be concerned about preserving your money. The person just watching cable TV might never know that.

If Graham and Dodd were alive today, what advice do you think they’d offer to investors?

SK: I’ve thought a lot about that. Their focus would probably be on not worrying about where something trades tomorrow or next week. You need to worry about where the company and the stock will be in three to five years. If you can buy something today with little chance of permanent impairment and a high likelihood that you’ll double your money over the next five years, you should go ahead and do it.

As always, they’d argue to be careful and make very sure nothing terminates your upside option, which would suggest staying away from highly leveraged situations. They’d probably tread very lightly with financials, although not ignore them, because some companies with clean books of business and great management are likely to take advantage of the lending environment today.

As Graham, Dodd and Buffett have all said, you should always remember that you don’t have to swing at every pitch. You can wait for opportunities that fit your criteria and if you don’t find them, patiently wait. Deciding not to panic is still a decision.