Most investment professionals and even many individual investors know of Benjamin Graham. He is the father of value investing and mentor to Warren Buffett. For generations, investors have relied upon and sought to duplicate his philosophies about valuing securities and prudent investing that were first outlined in the 1934 edition (and multiple updates) of "Security Analysis."
Graham's second book (along with his partner David Dodd), "The Intelligent Investor," published first in 1949, outlined the behavioral obstacles that must be overcome to achieve investing success over a half century before the Nobel Prize in Economics was awarded to behavioral psychologists Daniel Kahneman and Amos Tversky in 2002.
Most investors familiar with Graham and his philosophy know that he had a long and distinguished career. Far fewer know that his viewpoints progressed quite a bit over the years as the stock market evolved to the point that most of his still-famous ideas are no longer relevant. Selected passages from his final public interview in 1976 will change the way you think about traditional value investing, active management, the financial advisory industry and your most important considerations as an investor.
Graham on the reliability of long-term gains in stocks and the irrationality of short-term price swings:
"Common stocks have one important characteristics and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings - incidentally, with no clear-cut plus or minus response to inflation. However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble - i.e., to give way to hope, fear and greed."
Graham on how the financial industry misrepresents what they can and should be doing to help investors:
"Most of the stockbrokers, financial analysts, investment advisers, etc., are above average in intelligence, business honesty and sincerity. But they lack adequate experience with all types of security markets and an overall understanding of common stocks - of what I call "the nature of the beast." They tend to take the market and themselves too seriously. They spend a large part of their time trying, valiantly and ineffectively, to do things they can't do well."
Graham giving more specifics:
"To forecast short- and long-term changes in the economy, and in the price level of common stocks, to select the most promising industry groups and individual issues - generally for the near-term future."
Graham on whether or not investors can beat an index:
"No. In effect, that would mean that the stock market experts as a whole could beat themselves - a logical contradiction."
Graham on the advantages that individual investors have over large institutional investors in terms of their ability to diversify more broadly outside of the largest-cap stocks (i.e., small and value companies):
"The typical investor has a great advantage over the large institutions. Chiefly because these institutions have a relatively small field of common stocks to choose from - say 300 to 400 huge corporations - and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor's Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list - say, 30 issues or more - that offer attractive buying opportunities."
Graham on the need to view investing as a long-term pursuit, and to have a disciplined and structured approach to managing your portfolio:
"(1) The individual investor should act consistently as an investor and not as a speculator. This means, in sum, that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase - in other words, that he has a margin of safety, in value terms, to protect his commitment. (2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase - say 50 to 100 per cent - and a maximum holding period for this objective to be realized - say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market. (3) Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings."
Graham on whether he believed traditional, "bottoms-up" security analysis was still a worthwhile endeavor:
"I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors."
Graham introducing a modern approach to value investing:
"Essentially, a highly simplified one that applies a single criteria or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole - i.e., on the group results - rather than on the expectations for individual issues."
Rereading this interview, as I have done many times throughout the years, I'm continually amazed at Graham's foresight from almost 40 years ago to describe the modern world of investing and capital markets.
Graham reminds us on multiple occasions that while the long-term trajectory of the stock market is fairly reliable, the short-term direction of securities prices is unknowable, random and sometimes without basis. Then why is so much of the financial industry still focused on short-term outcomes and results?
Graham takes the financial services industry to task for the improbability of their claims - forecasting the future direction of markets, identifying in advance outperforming managers or accomplishing that feat personally. What has changed? Active managers and market timers, albeit in more sophisticated forms, still dominate the financial industry. Notice, too, that Graham does not denounce all financial professionals, instead only those who insist on charging for services that either have no value or that cannot be reasonably performed.
Graham was a proponent of basic indexing despite the fact that, in 1976, only institutional investors had developed and invested in index funds, and the first retail index fund from Vanguard was roundly criticized.
In his directives to individual investors, I see a clear precursor to the convention today that diversifying across different kinds of stocks (small cap and international), and not just holding large-cap US stocks, is the best course of action. I see him laying out a premeditated approach to managing a portfolio that sounds a lot like a modern Investment Policy Statement with defined rebalancing parameters. Graham even supports the practice of balanced portfolio allocations with safe fixed income employed for its risk-reducing properties.
But most important of all is his outright denunciation of individual, value-oriented security analysis and management. Graham revealed that a more quantitative approach that relies on one or two fundamental variables applied across an entire market or asset class represented the most effective manifestation of his earlier teachings. Clearly, markets evolve, the flow of information improves, competition for alpha intensifies until it becomes non-existent, and in this world, a low-cost, diversified "asset-class" approach to value investing is the only one with a fighting chance of outperforming broad markets over time and represents the highest probability of achieving one's long-term goals.
This might sound like a biased conclusion from an advisor who personally owns and manages value-oriented, asset-class portfolios similar to the ones that Graham speaks in favor of. But the fund rating company Morningstar is available to substantiate my claims. In the 15 years ended August 10th, comparing the DFA value funds (which apply 2 basic valuation metrics to an entire asset class: price/book and profitability) to the active managers who have survived the entire period as well as other common benchmarks, we find:
- the DFA US Large Cap Value Fund (MUTF:DFLVX) outperformed 93% of large cap value managers, beat the Vanguard S&P 500 Fund (MUTF:VFINX) and the Vanguard Value Index Fund (MUTF:VIVAX) by 1.5% per year.
- the DFA US Small Cap Value Fund (MUTF:DFSVX) outperformed 86% of small cap value managers, beat the Vanguard Small Cap Index Fund (MUTF:NAESX) by 0.7% per year and the Vanguard Small Value Index Fund by 0.8% per year.
- the DFA Int'l Value Fund (MUTF:DFIVX) outperformed 88% of international large cap value managers, beat the Vanguard Developed Markets Index Fund (MUTF:VTMGX) by 0.9% per year and the Vanguard Int'l Value Fund by 0.4% per year.
- the DFA Int'l Small Cap Value Fund (MUTF:DISVX) outperformed 99% of international small cap value managers, and beat the Vanguard Int'l Explorer Fund by +2.3% per year.
This, in my opinion, is Benjamin Graham's legacy. The willingness to evolve beyond an approach that served him so well over his professional career and have the foresight to see how the rapid technologization of the stock market would require a more streamlined, robust and systematic approach to finding higher-returning stocks. And to also foresee that this formulaic process would also work best in a world where the only resistance to change is human nature, our fallibility and their detrimental impacts on our wealth.
What do you think? What did you take away from Graham's final words? Am I reading them through the lens of confirmation bias, or is there merit in my interpretation? Feel free to share your thoughts in the comments section.
Past performance is not a guarantee of future results. Index performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. You cannot invest directly in an index. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.
Disclosure: I am/we are long DFLVX, DFSVX, DFIVX, DISVX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.