Value investing? Don’t follow Ben Graham
Over the years, there has been some confusion about our approach to value investing. And even though a majority of my 2010 book, Value.able discussed the importance of identifying quality businesses, which included a company’s bright prospects for growth, many investors and commentators have been fixated on the value component of the philosophy.
And while whilst many use Ben Graham’s models for intrinsic value to evaluate the attractiveness of companies, we don’t. Let me explain why.
Just before I begin though, I want you to know I have always been nervous about advocating against a strict Graham-approach. It always puts a few noses out of joint. What follows are references to what I believe are the pertinent quotes that I have read and that brought me and my colleagues to, or reinforced, the conclusion that value investors should move on from many parts of Graham’s framework.
In the 1940’s Benjamin Graham (who passed away in 1976) was regarded “as a sort of intellectual dean of Wall Street, [and] was one of the most successful and best-known money managers in the country.”[1] In 1949, an eager Warren Buffett read Graham’s book The Intelligent Investor and the rest, as they say, is history.
Warren Buffett regards Graham’s book Security Analysis as the best text on investing, regularly referring investors to that time, and his other seminal work, The Intelligent Investor. You may also know one of my other favourite Graham publications, The Interpretation of Financial Statements.
Yet, whilst Buffett remains an adherent and advocate of Graham’s Mr. Market allegory and the Margin of Safety concept, thanks to his long-time partner at Berkshire Hathaway, Charlie Munger, he has moved far from the original techniques taught and applied by the man described as the ‘father of value investing’.
Ben Graham advocated a mostly, if not purely, quantitative approach to finding bargains. He sought to buy businesses trading at a discount to net current asset values – what has been subsequently referred to as ‘net-nets’. That is, he sought companies whose shares could be purchased for less than the company’s current assets – the cash, inventory and receivables – minus all the liabilities. Graham also felt that talking to management was sort of ‘cheating’ because smaller investors didn’t have the same opportunity.
Whilst the method had been very successful for Graham and the students who continued in his tradition, people like Warren Buffet, Walter Schloss, and Tom Knapp, Graham’s ignorance of the quality of the business and its prospects did not impress Charlie Munger. Munger thought many of Graham’s precepts “were just madness”, as “they ignored relevant facts”.[2]
So while Munger agreed with Graham’s basic premise – that when buying and selling, one should be motivated by reference to intrinsic value rather than price momentum, he also noted, “Ben Graham had blind spots; he had too low of an appreciation of the fact that some businesses were worth paying big premiums for” and “the trick is to get more quality than you pay for in price.”[3] When Munger referred to quality, he was likely referring to the now common belief held by many sophisticated investors that an assessment of the strategic position of a company is essential to a proper estimation of its value.
In 1972, with Munger’s help, Buffett left behind the strict adherence to buying businesses at prices below net current assets when, through a company called Blue Chip Stamps, they paid three times the book value for See’s Candies.
See’s Candies is a U.S. chocolate manufacturer and retailer – whose product I have purchased and eaten more than my fair share of, whose factory I have toured, and whose peanut brittle ranks with the best I have ever tasted.
Buffett noted; “Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move me on from Graham’s limiting view. It was the power of Charlie’s mind. He expanded my horizons”[4] and, “… My guess is the last big time to do it Ben’s way was in ’73 or ’74, when you could have done it quite easily.”[5]
So Buffett eventually came around, and the final confirmation, for those still advocating the Graham approach to investing, that a superior method of value investing exists was this from Buffett; “boy, if I had listened only to Ben, would I ever be a lot poorer.”[6]
Times in the U.S. were of course changing as well, and it is vital for investors to realise that the world’s best, those who have been in the business of investing for many decades, do indeed need to evolve. In the first part of the twentieth-century industrial manufacturing companies, for example, in steel and textiles, dominated the United States. These businesses were loaded with property, plant and equipment – hard assets. An investor could value these businesses based on what a trade buyer might pay for the entire business or just the assets, and from there, determine if the stock market was doing anything foolish.
But somewhere between the 1960s and 1980, many retail and service businesses emerged that had fewer hard or tangible assets. Their value was in their brands, mastheads, reach, distribution networks, or systems. They leased property rather than bought it. And so, it became much more difficult to find businesses whose market capitalisation was lower than the book value of the business, let alone the liquidating value or net current assets. These companies’ profits were generated by intangible assets and the hard assets were less relevant.
To stay world-beating, the investor had to evolve. Buffet again: “I evolved…I didn’t go from ape to human or human to ape in a nice, even manner.”[7]
Many investors cling to the Graham approach to investing even though some, if not many of his brightest and most successful students, moved on decades ago.
And today, technology companies – those platform businesses attracting millions, if not billions of monthly users – have even fewer hard assets than the retailers that emerged after the 1960s. Their extraordinary ability to generate rising rates of return on equity, even as their equity grows, does not lend itself to valuation using the Graham approach. These businesses are the new leaders, the gargantuan monopolies whose wealth grows faster than any regulator can analyse and respond, and whose convenience renders their dismantling a major impost on society.
Value in these businesses can only be found through an understanding of their growth prospects, or perhaps when the broader market convulses and takes the share prices of these mega-ROE companies with it.
If you are reading this and want to adopt a value investing approach, there is no doubt in my mind that your search for solutions will take you into an examination of the traditional Graham application of value investing. It is my hope, however, that these words will serve as a guide towards something more modern, more relevant and, whilst can’t be guaranteed, more profitable.
[1] Damn Right. Janet Low. John Wiley & Sons 2000. Pg 75
[2] Damn Right. Janet Low. John Wiley & Sons 2000. Pg 77
[3] Damn Right. Janet Low. John Wiley & Sons 2000. Pg 78
[4] Ibid
[5] Robert Lezner, “Warren Buffett’s Idea of Heaven” Forbes 400, October 18, 1993 p.40
[6] Carol J. Loomis, “The Inside Story of Warren Buffett,” Fortune, April 11, 1988 p.26
[7] L.J.Davis, Buffett Takes Stock,” New York Times Magazine, April 1, 1990, pg.61.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
J
:
good article.