Investment Strategy Review: 'Graham And Dodds-Ville'

Includes: AZN, CBIO, CSCO
by: Mike Arnold

I woke up one morning recently and it occurred to me: you and I most definitely can outperform the broad market indices. I confide that my investment performance has been frustrating since I started my portfolio in August 2007, which generally consisted of regular contributions to index funds held in retirement accounts.

It turns out beginning the wealth accumulation phase of my life just two months before the market reached its apex had a drastic negative effect on my investment performance. Mostly because I attempted to time the market and make broad asset allocation shifts as a result of headlines I was reading in The Wall Street Journal and elsewhere. In short, I let peripheral factors cloud my thinking so that the deleterious effect of mercurial investor behavior commanded my decision making. I wasn't investing, I was only saving. Those are two completely different concepts.

Saving means spending less than you earn; conversely, investing is using those saved dollars to buy undervalued securities identified through rigorous analysis with the goal of capital appreciation and passive income creation. By simply throwing dollars into an S&P 500 stock index fund, an international stock index fund and a bond fund, I thought I was assured investment success. That is not completely so. It depends how you measure success. The investment results I generated from that strategy were nothing short of tragic.

To exacerbate the problem, I enrolled in the Chartered Financial Analyst program and learned the elaborate algorithms, fancy formulas, sophisticated statistical models and other investment rigmarole extolled by academicians and the elite finance establishment. By all accounts, I am pleased I put in the effort, and I would encourage others in the investment industry to do the same. The curriculum introduced me to the investment vernacular, and most importantly, to how others value marketable securities.

But it left me with the suffocating impression that my capabilities for security analysis were somehow inadequate compared to the analysts on Wall Street and those market moving institutional investors. Not to mention that the investment game appeared to me rigged, with high frequency traders exchanging shares at a dizzying pace, insider trading scandals, massive Ponzi schemes, and a general sense of disgust for those scoundrel bankers who took advantage of unsuspecting investors by hawking toxic assets while improperly disclosing the risk of those assets.

Today, those fears of inadequacy have been assuaged because I have unequivocally embraced the principles of value investing, whereby one only invests in securities that they understand and that trade far beneath their intrinsic value, electing to hold cash when undervalued investment opportunities cannot be identified. I understand now that it is entirely possible, and profitable, to be opportunistic; that is, to offer liquidity to those desperately trying to find an exit, and to sell those securities that have become in favor by investors for the right price.

And by opportunistic, I mean playing by the rules and engaging in a transaction with a consenting counter-party, each side knowing all the relevant facts of that particular transaction. Value investors are opportunistic by nature; they dampen the risk of further security price declines and intervene in precipitously falling markets by providing liquidity when no one else wants to. That makes us, by definition, contrarians.

How can the market possibly be efficient when it is governed by erratic investor psychology? The analysts on Wall Street and institutional investors are largely driven by group think and other investment constraints, and therefore fall victim to herd mentality more than you or me. Take, for example, Cisco Systems (NASDAQ:CSCO). Was Cisco worth only $13.50 per share in August 2011, when cash and equivalents were roughly half its market capitalization?

My answer is a resounding no. But I remember very vividly watching the stock drop into the abyss, partly because of the exogenous factor that was the US sovereign debt downgrade, but mostly because Cisco had become the media's most wanted target. It seemed like everyone and their mother was criticizing Cisco for its shortcomings. It was a similar fact pattern for Hewlett Packard (NYSE:HPQ), General Electric (NYSE:GE) and a multitude of other S&P 500 index members in 2011.

The herd pushed the prices of those securities to such low levels that they offered value investors an adequate margin of safety to put their money to work, meanwhile skittish investors hurried to the nearest door and accepted a fire sale price to exit the ostensibly crumbling building. Did Cisco not offer a better risk/reward ratio at $13.50 per share than at $20? I think so. Had the fundamentals of the business changed such that Cisco was worth 35% less? I think not. Cisco has since outperformed the S&P 500 index and now trades at about $20 per share, closer to its intrinsic value. The risk/reward ratio, therefore, has been altered due to the rise in the security price relative to underlying value and now provides investors a smaller margin of safety, even though it may appear less risky than it did last summer.

As a general rule, a member of S&P 500 index that adorns the front page of a newspaper because its business model is associated with dire predictions, that company is probably a pretty good investment if its stock price has taken a similar beating. How can that be, you ask? Isn't that company broken because the journalist said so? Isn't a stock more risky when it's fallen 35% from its 52-week high? Or when it has a high "beta"? Beta is a favorite Greek symbol of finance alchemy, and is supposed to represent how risky a security is by tracking how much it moves in price relative to the price movement of the market as a whole, a measure of volatility. Volatility, though, is an inaccurate measure of risk; that is, beta is a relative measure of risk, not an absolute one. Risk really should be measured by how close a marketable security trades relative to value. A stock that trades just below, at par or above underlying value is far riskier than one that trades at a 50% discount to underlying value, irrespective of how much that stock moves up or down in price relative to the broader market on a daily basis. That is because a security that trades at elevated price levels relative to value has farther to fall should the tide of investor sentiment turn negative.

A Methodical Walk Down 'Graham and Dodds-Ville'

Readers well versed in finance literature understand the title of this article. It's a juxtaposition of the investment philosophies explained in Burton Malkiel's book "A Random Walk Down Wall Street" which discusses the virtues of indexing and Mr. Buffett's seminal essay "The Superinvestors of Graham-and-Dodds-ville" (pdf), which provides credible evidence to the value of stock picking. Each is definitely worth a read and both provide divergent ideologies: Mr. Malkiel postulates that investors cannot outperform the market, while Mr. Buffett offers that those who practice the disciplined approach of value investing can and regularly do outperform. For those suspicious readers of indexing orientation, Mr. Buffett acutely and eloquently questions how it is that he could pre-identify nine individuals, each of them handily beating the S&P 500 index, year in and year out, over a long time horizon.

Could it be that these nine individuals just happen to be the luckiest people in the investment world? Mr. Buffett would believe no; these nine individuals are not lucky, but achieved superior investment results by strictly abiding to the value investing principles learned under the tutelage of Ben Graham and David Dodd, the 'intellectual patriarchs' of the discipline. As far as I know, academicians have never, and I bet, can never refute the arguments laid out by Mr. Buffett, that the market is positively not efficient. Those arguments include:

  1. All nine portfolios had very little overlap at any time during the examination. Each super investor had varying degrees of concentration and diversification in the portfolios, owning securities from the full spectrum of the equity universe. Most importantly, each super investor made trading decisions independently of one another.
  2. Each super investor was identified prior to the examination. If Mr. Buffett had selected each investor after the results were in, then the veracity of the examination would be in question. It follows that the parable of the coin flipping contest is representative of what happens in the investment world; those winning individuals let luck get to their head, leading to overconfidence, a devious psychological flaw in the investment arena. Luck is very different from skill.
  3. Each super investor considers stocks as proportional interests in a business, not slips of paper to trade to others. Therefore, each attempts to exploit differences when price does not equal value. Market prices can be quite disparate from value at times.
  4. These super investors do not quibble with academic financial models such as the Capital Asset Pricing Model ("CAPM"), beta or covariance. They only care about price in relation to value, and buy only when an enormous margin of safety is achievable. Likewise, when engineers build a bridge, they insist that it has the ability to hold some exponential amount of weight in excess of the maximum weight of cars passing over it to avoid calamity.
  5. Risk and reward are negatively correlated. Buying at lower prices is less risky than at higher prices. If follows that there is greater potential for reward when investors take on less risk, even though that premise runs counterintuitive to how people generally perceive risk and reward.
  6. Each super investor adopted the principles of value investing immediately and absolutely when introduced to the concept that one can buy $1 worth of value for 50 cents.

The inexorable truth seems to me that price and value diverge quite often, and those with basic business appraisal skills and the appropriate mental make up can exploit those differences to achieve alpha, another Greek symbol which quantifies investment return in excess of the broad market (the premise behind this website's name).

There is more to be learned from Warren Buffett and other renowned investors, of course. I recommend value investors seek out the teachings of those before them if only to keep those value principles close in mind. For a reading list suggested by successful value investor Seth Klarman, click here.

Maxims to Improve Investment Results

To close out this analysis on the paradigm of value investing, I offer the following eight guidelines to improve investment results (the list is not exhaustive and is generally meant for personal investors):

  1. Keep cash in the investment portfolio. Although investors holding cash will underperform in a steadily rising market, they will outperform in a precipitously falling one. Investors who possess cash can easily purchase securities that have suddenly become bargains.
  2. Think about risk first, and return second. Investors will generate better investment results in the long run if they avoid a substantial loss of investment principle and therefore should be keenly aware of risk. That's because risk drives investment results by closely scrutinizing the potential for loss of investment principle. If, for example, an investor sustains a 50% loss, that investor needs a 100% return to claw back to even. Conversely, if one buys a security that is say, 60% undervalued, that investor would generate a 150% return if that security becomes fully valued; at a 70% undervaluation, a 233% return; at an 80% undervaluation, a 400% return. Of course, finding securities that are that severely mispriced is rare. But that is powerful math nonetheless.
  3. Another reason to hold cash in the investment portfolio is that investors never want to be under any compulsion to sell. One should always liquidate holdings on their own terms, either when a security is fairly valued or if one discovers a better bargain. It follows that it is desirable to minimize the overhead in one's life so there is no surprise need for liquidity which could cause a forced sale.
  4. Once an undervalued investment opportunity is identified, only open with half the intended position. There is no telling how long the market may remain irrational, so surely an investor would want to own more shares at a lower price if the underlying fundamentals of that investment remain unchanged. If investors only manage to fill half the intended position, I can think of worse outcomes than only realizing half the potential profit from an investment. Like sustaining a loss by being coerced to sell at an inopportune time because of an urgent need to raise cash (see #3 above).
  5. Know why others are selling. Is it because erratic investor psychology has subsumed decision making or have the business fundamentals eroded? If business value is indeed impaired, did the stock price drop further relative to the impairment? If so, astute investors may still find a bargain. Just look to Targacept (TRGT) who failed the first two of four Phase 3 Food and Drug Administration ("FDA") clinical trials in late 2011 related to its TC-5214 compound, a touted drug related to anti-depressive disorders. Targacept's business value was impaired as a result of those decisions, but by how much? The stock price plummeted about 75% between November and mid-December 2011 when the bad news was delivered, to below liquidation value. Even though Targacept lost business value, it likely didn't lose that much. Therefore, the drastic decline in the stock quote offered value investors a margin of safety because the market ascribed a value to Targacept's equity less than the amount of cash and equivalents on its books, and it traded at a negative enterprise value for some time. Targacept still has two FDA approval opportunities with respect to TC-5214, boasts a nice pipeline of other potential products, and has a strategic partnership with AstraZeneca (NYSE:AZN) who pays for a majority of the costs for those capital intensive FDA clinical trials. Surely there was value in excess of what nervous investors were willing to pay in December 2011. In short, to fully understand why others are selling is part of the due diligence process required before buying.
  6. Set limit orders for those investments identified as buys rather than market orders. Similar to selling on one's own terms, investors should buy on their terms too. Purchase price, of course, determines investment returns (see #2 above).
  7. Hold no more than fifteen securities in the investment portfolio. That should provide adequate diversification from individual company risk. Whatever benefit is forgone from further diversification is gained from detailed knowledge of the investments held. Investments require close attention and persistent monitoring of price in relation to value.
  8. Be like Steve McQueen. Or Steve Jobs. Be able to don a black turtle neck, even in the most awkward of social situations. In other words, be cool. If investors can't muster that, then take a yoga class or engage in meditation. I am serious. Investors need to find a way to control their emotions in order to have an edge. Loss aversion, overconfidence and a number of other human behavioral traits and psychological afflictions are treacherous to investment results.

Believe me; it's easier to write about investment discipline than it is to practice it. But I am certainly trying my best to adhere to the principles laid out by Benjamin Graham and David Dodd so I too can achieve superior investment results. I advise you do the same.

Disclosure: I am long TRGT; I recently sold CSCO.