Is Security Analysis Dead? Why Ben Graham Eventually Embraced Efficient Markets
Could the man who literally wrote the book on security analysis actually have thrown it all away? If you’re a value investor, or have already requested free net net stock picks , you’ve undoubtedly heard of the father of value investing himself, Benjamin Graham . Most investors come to Graham through the writings of Warren Buffett, and for good reason. Buffett has continuously called Graham the biggest investing influence in his life, so it’s only natural to pay homage to the legendary teacher. But Graham was also a legendary investor and prolific writer, producing two of the best investment books books ever written: Security Analysis and the Intelligent Investor. Both went on to become long running series. What many value investors are less aware of, however, is that in one of the last seminars given before his death, Graham actually rejected the idea that detailed security analysis added much value. Those comments were made available in an article titled “A Conversation With Benjamin Graham,” published in the Financial Analyst Journal, and are definitely surprising given Graham’s focus on dissecting a firm’s financial statements to uncover superior value investment opportunities. What exactly did he mean? What changed? The Death of Security Analysis The first thing you should recognize is that Graham still favored buying common stocks as part of an investment portfolio. In his words, “[The] investment value and average market price [of common stocks] 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.” A decent assessment of stocks in general, and it’s easy to see why. Given that stocks provide, on average, a higher average return than pretty much any other asset class, Graham was well justified in his assessment. But while Graham liked the idea of buying stocks, he also revealed a decided shift on how he viewed the practical use of detailed analysis. In his words, “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.” It’s shocking that Graham could be seen on the side of the efficient market crowd, given that he based his career on the ability of individual investors to make above average returns using his value investing techniques. When it came to institutional investors in general, Graham described another devastating handicap. “…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.” Give the ocean of analysts and mutual funds that are now choking the investment world, if Graham was right in 1976 when he made those remarks, things have only gotten worse. Yet, a number value investors have forged great track records since 1976, suggesting another path to great returns. Ben Graham’s New Path Forward Graham spent a lot of his investing life learning about securities and studying a wide range of investing strategies. It should be no surprise that Ben Graham’s shift towards believing in efficient markets still left open the possibility for great investment success. “…the typical investor has a great advantage over the large institutions. ………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” Professional investors often have to manage billions of dollars in a single fund, and most funds are well over $100 Million USD. Because of that, these managers only ever have a small pool of stocks to pick from. In comparison, individual investors can choose among far more investments, including the stocks of tiny companies that professional investors just can’t touch. This means that small private investors face much lower competition if they stick to small, mirco, and nano cap stocks. But how did Graham think a small investor should capitalize on this? “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.” Ben Graham clarifies, “[I recommend] a highly simplified [strategy] that applies a single criteria or perhaps two criteria to the price [of a stock] 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.” Benjamin Graham’s suggestion for a value strategy is exactly what many investors today call “quantitative value investment strategies,” or “mechanical” strategies. He continues, “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.” Graham’s recommended buy and sell strategy is much simpler than the strategy he used to favor, thorough analysis in the hopes of uncovering unrecognized value. According to Ben Graham’s comments, investors can forget about industry and competitive analysis, or even income and balance sheet assessments, in favor of buying a diversified group of stocks based on simple metrics. Ben Graham did also have something to say about the sort of metrics that investors should be looking for. His favorite, in his words, “…[this] technique confines itself to the purchase of common stocks at less than their working-capital value, or net-current-asset value, giving no weight to the plant and other fixed assets, and deducting all liabilities in full from the current assets. We used this approach extensively in managing investment funds, and over a 30-odd year period we must have earned an average of some 20 per cent per year from this source.” Graham used to buy 100s of “working-capital value,” or net net, stocks to fill out his portfolio yet was able to earn returns in excess of 20% per year. That’s a great record, but as I’ve written to those who’ve requested free net net stock picks , by using the growing body of research covering net nets to focus on the best possible opportunities investors should be able to earn even better returns. That’s the approach that I’ve adopted, and it’s worked quite well. As Graham describes, “…we found it almost unfailingly dependable and satisfactory in 30-odd years of managing moderate-sized investment funds. ………I consider it a foolproof method of systematic investment–once again, not on the basis of individual results but in terms of the expectable group outcome.” What other endorsement do you need? Ben Graham’s Net Net Stock Problem There is a well known problem when it comes to buying net nets, however. They tend to dry up as markets advance. This has been a problem for people who insist on only investing in their own domestic market. Graham’s experience was no different. “For a while, however, after the mid-1950’s, this brand of buying opportunity became very scarce because of the pervasive bull market. But it has returned in quantity since the 1973-74 decline. In January 1976 we counted over 300 such issues in the Standard & Poor’s Stock Guide–about 10 per cent of the total.” I started Net Net Hunter to solve this very problem. By branching out to friendly international markets, investors can widen the pool of available investment candidates enormously. This is the same technique legendary Canadian value investor Peter Cundill employed during his career. But by looking internationally, investors don’t just find more net nets, they can also significantly improve the quality of the net nets in their portfolio. So while Ben Graham gave up on detailed security analysis at the end of his life, he by no means abandoned hope that small investors can beat the market by significant margins if they play their cards right. When it comes to your own portfolio, you have a tremendous advantage over the pros if you’re willing to look at tiny companies and buy a diverse group of ugly, beaten down, stocks such as Graham’s famous net nets. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.