If you are new to our Value.able community, Ben Graham’s concepts may be foreign to you. Ben is the author of Security Analysis. He is regarded as the father of security analysis and the intellectual Dean of Wall Street.
I support Ben’s revered status and what he has to say on the subject of investing, but perhaps controversially, I also believe that, had he access to a computer that allowed him to properly test his ideas, he may not have reached all of the same conclusions.
It is exactly one year since I first penned some of my thoughts about Ben Graham on this blog here: http://rogermontgomery.com/should-a-value-investor-imitate-ben-graham/
There are many things that Ben said that not only make sense, but has also made significant contributions to investment thinking. Indeed they have become seminal investment principles. These are the things to which Value.able investors should hold firm.
Ben Graham authored the Mr Market allegory and also coined the three most important words in value investing: Margin of Safety. In fact Ben said this: “Confronted with the challenge to distill the secret of sound investment into three words, I venture the motto: Margin of Safety”
These are two concepts that value investors hold dear and which have, in many different ways, become a formal part of our Value.able investing framework.
Mr. Market is of course a fictitious character, created by Ben to demonstrate the bipolar nature of the stock market.
Here is an excerpt from a speech made by Warren Buffett about Ben Graham on the subject:
“You should imagine market quotations as coming from a remarkably accommodating fellow named Mr Market who is your partner in a private business. Without fail, Mr Market appears daily and names a price at which he will either buy your interest or sell you his.
“Even though the business that the two of you own may have economic characteristics that are stable, Mr Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains…
“Mr Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow.
Transactions are strictly at your option…But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr Market is there to serve you, not to guide you.
“It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”
If you have read Value.able you will understand Margin of Safety, know exactly what a suitable Margin of Safety is and also how to apply it to Australian stocks.
Despite the high profile of these two enduring lessons, I believe there is a third observation of Graham’s, which is equally important. Fascinatingly, with the benefit of computers, I can also demonstrate that Graham was spot on.
Graham was paraphrased by Buffett in 1993 thus:
“In the short run the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long run, the market is a weighing machine”
What Graham described is something that, as both a private and professional investor, I have observed myself; in the short term the market is a popularity contest – prices often diverge significantly from that which is justified by the economic performance of the business. But in the long-term,prices eventually converge with intrinsic values, which themselves follow business performance.
Have a look at the amazing chart below.
(c) Copyright 2011 Roger Montgomery
Its Qantas (ASX:QAN, MQR: B3, MOS-44%): – its my ten-year history of price and intrinsic value (and three year forecast of intrinsic value which updates daily). Now right click on the chart and open it in a new tab. Zoom in. Now stand back from your computer screen. What do you see?
First you will notice two intrinsic values – a range is produced. Next you might notice that there have been short term bouts of both optimism and despondency and this is reflected in the short term share price changes. The final observation you might make and which the charts make most powerfully, is that since 2001, the intrinsic value of Qantas, which is based on its economic performance has, at best, not changed. Look closer and you will notice that the intrinsic value of Qantas today (2011) is lower than it was a decade ago. Even by 2013, intrinsic value is not forecast to be materially different from that of 2002.
Just as Ben Graham predicted, the long-term weighing machine has correctly appraised Qantas’ worth. Unsurprisingly, the share price today of Australia’s most recognised airline, is also lower than it was a decade ago. And unbelievably, the total market capitalisation of Qantas today is less than the money that has been ‘left in’ and ‘put in’ by shareholders over the last ten years!
These charts aren’t just easy or nice to look at, they are incredibly powerful. If you can calculate intrinsic values for every listed company, you can turn the stock market off and simply pay attention to those values. Then, during those times that the market is doing something irrational, you can take advantage of it or ignore it, just as Ben Graham advised.
Unless you can see a reason for a permanent change in the prospects of Qantas, the long-term trend in intrinsic value gives you all the information you need to steer well clear of this B3 business.
Now have a look at the second chart. What does it tell you?
(c) Copyright 2011 Roger Montgomery
There have been short-term episodes of price buoyancy, but over the long run the weighing machine has done its work. The intrinsic value has not changed in ten years so, over time, the share price has once again reflected the company’s worth and gradually but perpetually fallen until it reaches intrinsic value. This is my ten-year historical price and intrinsic value chart (and three year forecast) for Telstra (ASX:TLS, MQR: B3, MOS:-32%).
What about an extraordinary A1 business?
Sally Macdonald joined Oroton (ASX:OTN, MQR: A1, MOS:-17%) as CEO in 2005/06. Observe the strong correlation between price and value since Sally’s appointment.
(c) Copyright 2011 Roger Montgomery
I acknowledge that there are critics of the approach to intrinsic value we Value.able Graduates follow. But like me, you should be delighted there are. Indeed, we should be encouraging departure from this approach!
The critics are necessary. Not only do they help refine your ideas, but without them, how else would we be able to buy Matrix at $3.50, Forge at $2.60, Vocus at $1.60 or Zicom at $0.32! And how else would we be able to navigate around and away from Nufarm or iSoft, and not fall into the trap of buying Telstra at $3.60 because the ‘experts’ said it had an attractive dividend yield? If it was universal agreement I was after, I would just keep writing about airlines.
The Value.able approach works. If you have been visiting the blog for a while, you will know this only too well.
The above charts (automatically updated daily – and I have one for every, single, listed company) confirms what Ben Graham had discovered without the power of modern computing; In the short run the market is indeed a voting machine, and will always reflect what is popular, but in the long run the market is a weighing machine, and price will reflect intrinsic value.
If you concentrate on long-term intrinsic values and avoid the seduction of short-term prices, I cannot see how, over a long period of time, you cannot help but improve your investing.
…And in case you are wondering about the link between Ben Graham and the photograph of Comanche Indian ‘White Wolf’… the photo of White Wolf was taken in 1894 – the year Ben Graham was born.
HOMEWORK RESULTS: I will publish the holiday results homework on Monday. Thank you to all who participated. It is vital what you continue to practice your technique. With repetition you’ll get to the point where you can simply ‘eye-ball’ Value.able intrinsic value.
Posted by Roger Montgomery, author and fund manager, 29 April 2011.
