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Why Graham and Dodd (Ultimately) Works

"I bought stock X at book value, and it went down to half of book value," wailed one investor. It happens. Even a value investing "don't lose money" methodology doesn't work EVERY TIME. But properly tested and applied, it seems to have worked over the long term.

On the other hand, a buyer of overpriced growth stocks can score a string of gains. As long as s/he doesn't overstay his or her welcome. Which likely means smaller gains.

The principles can be illustrated by the Dow, whose value can range from one half of our proprietary "investment value metric" (now about 7000), to about three times that, or over 20,000. Yes, Jeff Miller, a 20,000 Dow is within the realm of possibility. But so is a 3500 Dow (half of 7000), which is our revised "Prechter" metric. Consider those the ceiling and the floor.

So from a Dow of just over 10,000, the potential upside is 2 times, but the potential downside is two-thirds. That's not really an appetizing risk-reward relationship, because the potential downside is greater than the reciprocal of the upside (two-thirds versus one half.)

On the other hand, the Dow WAS attractive in March 2009 below 7000, just below investment value. Then, the down side was only one-half (not two thirds). And the upside was THREE times.

Ben Graham didn't like "best ideas" or "highest conviction" picks, because he was agnostic about the performance of individual stocks. What he was firm on was the likely performance of a large number of stocks in the AGGREGATE. Hence he envisioned investing in many small positions (of low valuations), on the theory that individual wins would be larger than individual losses.

Suppose you had a group of 50 stocks, each with a 50-50 chance of TRIPLING, or falling to half price. On balance, you'd come out way ahead. Change those parameters to doubling or losing two-thirds. You'd still probably come out ahead, but not by much. And the margin of safety is non-existent. You'd probably do better buying the bonds of these companies.

So Ben Graham would buy stocks when the risk-reward ratios were favorable, and bonds otherwise.