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Part IV

15 November 2000

...continued from Part III

In the old legend the wise men boiled down the history of mortal affairs into the single phrase ‘this too shall pass.’ Confronted with a like challenge to distil the secret of sound investment into three words, we venture the motto ‘margin of safety.’ This is the thread that runs through all the preceding discussion of investment policy.

Benjamin Graham
The Intelligent Investor

Two key characteristics of Graham-and-Dodd value investors’ thinking and behaviour were implicit in the premises about risk set out in Part I. They percolated closer to the surface in Part II and became explicit in the investment examples set out in Part III.

The first, which we have called the acceptance rate, refers to the striking extent to which value investors rank or prioritise their options and act only upon those which appear to have the shortest odds of achieving their long-run intended consequences. The second and closely-related characteristic is the accuracy rate of successful value investors’ decisions; i.e., the extent to which they are able to ascertain whether a particular asset can be purchased at a market price which is significantly lower than its intrinsic value. Acting in tandem, these characteristics attenuate the overall risk which inheres in any investment. A behavioural consequence of these characteristics is value investors’ subjective willingness to ‘exchange’ specific risks. They are happy to forego possible financial gains (i.e., commit more ‘Sins of Omission’) in order to avoid actual losses (i.e., execute fewer ‘Sins of Commission’).

Graham-and-Dodd value investors thus emphasise the logic (including basic maths and probability) and evidence which identifies discrepancies between market prices and intrinsic values – and thereby increases the accuracy rate of their decisions. They also place a premium upon behaviour which reduces their acceptance rate and concentrates their portfolios upon the most egregious of these discrepancies. Value investors’ assumptions (including their conception of risk), analyses and behaviour thereby tend cumulatively to create what Graham called the margin of safety. This circular outlines this Rosetta Stone of Graham-and-Dodd value investing. It concludes that

  • investment risk management as value investors practice it consists in attitudes and actions which create and maintain a margin of safety;
  • in sharp contrast, investment risk management as conventionally practised consists in attitudes and actions which discount or ignore the margin of safety – and thus, as Graham-and-Dodders see it, increase investment risk.

Characteristic #1: The Acceptance Rate, Concentration and Diversification

Graham-and-Dodd value investors are selective investors. In the stylised example set out in Part III, their 20-80 acceptance rate meant that only 20 of the 100 potential investments were admitted into the portfolio. Value portfolios are therefore concentrated in the sense that they consist exclusively in assets whose intrinsic value is significantly greater than their purchase price. Graham noted that “a good part of [Graham-Newman Corp.’s] operations in Wall Street has been concentrated on the purchase of bargain issues...” Definitions of ‘bargain’ vary from one Graham-and-Dodder to another. Graham and one of his students and colleagues, Walter Schloss, focussed upon ‘cigar butts’; another student and colleague, Warren Buffett, is best-known for his concentration upon consumer franchises. All, however, are united in their pursuit of a wide discrepancy between market price and intrinsic value.

At the same time, however, value portfolios are diversified in the sense that they tend to contain a heterogeneous group of ‘safe’ assets. In Graham’s words “there is a close logical connection between the concept of safety margin and the principle of diversification. One is correlative with the other. Even with the margin in the investor’s favour and individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.” As a rough-and-ready rule of thumb, Graham concluded that “if such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favourable result under ‘fairly normal conditions’ becomes very large.”

Characteristic #2: The Accuracy Rate

Graham emphasised that “the concept of the margin of safety. rests upon simple and definite arithmetical reasoning from statistical data.” Graham-and-Dodd value investors are therefore a relentlessly logical and analytical lot. They strive to maximise the accuracy rate of their investment decisions, i.e., the extent to which they are able consistently to ascertain whether a given asset’s market price is significantly lower than its intrinsic value.

To do so they follow three strategies. First, they strive to increase in the quality and quantity of the information to which they have access. In practice they tend to be voracious consumers of primary information (i.e. raw statistical data, company financial statements and so on) and either discount or ignore secondary information which has been mediated by brokers, advisors, analysts and journalists. Second, they  seek to improve their ability to interpret this information; and third, they attempt to identify and to reduce the psychological biases which mar their judgement (see, for example, Massimo Piattelli-Palmarini’s excellent book Inevitable Illusions: How Mistakes of Reason Rule Our Minds). “Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”

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Price, Value and Margin of Safety

The ownership of an asset, as Part I emphasised, confers the right to receive a stream of earnings which that asset is expected but not guaranteed to generate. Because different investors will use different assumptions and methods to estimate it, an asset’s value is a partially-subjectivist phenomenon; and because the future is inherently uncertain, an investor’s estimate of an asset’s value will necessarily be imprecise. Nonetheless, the lower an asset’s market price relative to its estimated value – or, equivalently, the higher its estimated value relative to its price – the greater the margin of safety which accompanies its purchase.

The crux of Graham-and-Dodd value investing – and of value investors’ practice of ‘risk management’ – therefore consists in the purchase of assets whose intrinsic value (according to the investor’s reasoning, evidence, acceptance rate and accuracy rate) is significantly greater than its market price. Value investors buy and hold these assets until market price significantly exceeds estimated value. On 11 March 1955, at the conclusion of his testimony to the Committee on Banking and Commerce of the U.S. Senate (Chaired by Sen. William Fulbright of Missouri) Graham summarised its essence:

Chair: One other question and I will desist. When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – by advertising, or what happens? (Rephrasing) What causes a cheap stock to find its value?
Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. [But] we know from experience that eventually the market catches up with value. 

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Value Investing and Institutional Speculation

The basic difference between investors and speculators (as Graham and Dodd defined them) lies in their attitude towards market prices in general and short-term price fluctuations in particular. Investors distinguish sharply between the price and value of a stock, bond or title to real estate. They focus upon the business operations which underlie a security, and pay attention to the volatility of its price only to the extent that it enables them to buy a suitable security at a reasonable or bargain price. Speculators, in contrast, regard a security as nothing other than a piece of paper and consider its price and value – to the extent that they think about value at all – as synonyms. They ignore the economic fundamentals of the business whose pro-rata ownership the security confers; concentrate on ‘the market’ and obsess about the volatility of the prices of individual securities and ‘the market’ as a whole; and try to anticipate short-term price trends and fluctuations.

Speculators thus tend to buy and sell in rapid succession whilst investors intend to buy and hold for the long term (five years or more). Speculators, in other words, ignore what individual businesses are doing and will do in the years ahead and focus upon what they expect other speculators to do in the days and weeks ahead.

Given Graham and Dodd’s distinction, it follows that many large investment institutions and prestigious money managers speculate rather than invest. Moreover, their tendency to do so is long-established. Lord Keynes, one of the twentieth century’s most influential economists, independently observed and decried this tendency during the 1930s. He noted in The General Theory of Employment, Interest and Money that the conventional management of investments strongly resembles a contest in which the competitors strive to select the prettiest faces from a large number of photographs. The prize is awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole.

According to Keynes, in such contests each competitor has an incentive “to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not the case of choosing those which to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

Institutional speculation, as Graham and Keynes defined and criticised it, seems to be alive and well in Australia. A clear indication appeared in The Australian Financial Review on 9 June 2000 with respect to Australia’s largest (in terms of market capitalisation) listed company: “...many leading analysts maintain a strong buy recommendation on [News Corp.] stock. The chief equity analyst at [a leading institution] said she was sticking to an overweight position. ‘We continue to hold the stock because of the high number of analysts that recommend it as a buy and the boost it will receive from the bottoming of the Australian dollar. We also believe its value is attractive against its global peers, such as Time-Warner, Disney and Viacom.”

Another report in the AFR added on 20 June: “Fund managers said the [recent] strong trading in News Corp shares was driven by index fund buying. News Corp.’s weighting in key market indices increases in line with its capitalisation, forcing funds which track indices to life their holding of the stock. ‘They’re worried about the unknown’ one fund manager said. ‘They don’t believe the valuation but they’re effectively buying at that valuation so they don’t get burnt if News Corp keeps rising.’”

Graham sharply criticised such behaviour. In The Intelligent Investor he noted that “aside from forecasting the movement of the general market, much effort and ability are directed in Wall Street toward selecting stocks or industrial groups that in matter of price will ‘do better’ than the rest over a fairly short period in the future.” He concluded that “we do not believe [this endeavour] is suited to the needs and temperament of the true investor. As in all other activities that emphasize price movements first and underlying values second, the work of many intelligent minds constantly engaged in this field tends to be self-neutralizing and self-defeating over the years.” Further, “if as we suggest the average market level of most ‘growth stocks’ is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.”

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Conclusion: A Reprobate Breed

To a small number of investors – value investors in the Graham-and-Dodd mould – investment risk has nothing to do with the short-term ups-and-downs of a security’s market price. Instead, it has everything to do with the likelihood that a particular investment decision causes relative or absolute financial loss.

Risk therefore inheres in any investment and necessarily and unavoidably accompanies any decision to invest. Hence Graham and Dodd’s emphasis on the “. risks that are inherent in common stock commitments – risks which are inseparable from the opportunity of profit [and loss] that they offer, and both of which must be allowed for in the investor’s calculations.” Accordingly, “price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.” (italics added). As value investors conceive it, investment risk management comprises attitudes and actions which create and maintain a margin of safety and thereby reduce the risk which inheres in any investment operation. As it is conventionally practised, however, investment risk management attempts to reduce within acceptable bounds the short-term variability – particularly in a downwards direction – of an investment portfolio’s market worth. Whether or not it is successful, this attempt has nothing to do with investment risk as value investors conceive it. Indeed, and as successful investors from Keynes to Buffett have noted for almost three-quarters of a century, all too often conventional investment ‘risk management’ consists in herd-like actions which discount or ignore the margin of safety – and thereby increase risk.

In his “Superinvestors of Graham-and-Doddsville” speech, Mr Buffett concluded that “the secret has been out for fifty years ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the thirty-five years I’ve practised it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing. It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace and those who read their Graham and Dodd will continue to prosper.”

Circular 21
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