Reflections on Ben Graham
A couple weeks ago, Ben Claremon of the Compounders podcast wrote an article about his investing journey that started with the approach advocated by Ben Graham but eventually turned toward Buffett’s, away from deep value and toward “compounders”. The outlines of this story are probably fairly common. I say that because they match parts of my own investing journey as well.
Having read about Claremon’s journey, I felt inspired to write down some of my thoughts on Graham’s contributions, where they may differ from what has been written many times before. To do so, I need to split the analysis into two parts, one for his quantitative strategy and one for his approach to discretionary stock picking.
Graham for Quantitative Strategies
Without question, Graham contributions were critical to our understanding of quant strategies. In fact, I still think Graham doesn’t get enough credit.
In my opinion, there is stronger evidence for quantitative value investing in Graham’s book, The Intelligent Investor, than in the French & Fama paper that defined the “value factor”. I say that primarily because the second edition of the book included an out-of-sample study, showing that buying low P/E stocks outperformed even after the publication of the first edition! In contrast, the value factor has had approximately zero return since French & Fama published their paper. Finding a strategy that not only outperformed in the past but also continued to work for decades after publication is the holy grail, and Graham achieved that in the 1950s.
While Graham’s basic strategy no longer seems to work today, some simple variations of it do work. I wrote about one of those before, and I know of a couple of others as well. While you have to do a little more work to outperform now than what Graham described over 50 years ago, the success of these quantitative strategies remains a remarkable achievement.
Graham for Discretionary Strategies
Ben Claremon’s criticism of Graham was not for his quantitative strategies but rather with his approach to discretionary stock picking. Like Ben, I no longer find myself leaning on these tools, instead converting toward a more Buffett-like approach.
Here are the key points about value investing that, looking backward, I wish I had realized earlier and which would have pointed me toward Buffett’s approach instead of Graham’s:
- The Logical Conclusion of Fundamental Analysis
Any time you plan to hold a stock for even 1–3 years, you are ultimately making a bet on what other people will think about the stock. Listening to some value investors, you instead get the impression that you can send your DCF spreadsheet to the New York Stock Exchange and, as long as the math checks out, you get to sell at that price. Sadly, that is not how it works. Instead, the only price you can sell at is what others are willing to pay.
Some value investors like to say that their spreadsheet calculates an “intrinsic value” that is a “source of gravity” to which the stock price is drawn, but absent some sort of arbitrage mechanism, I see no reason to believe that this is true. To me, this sounds more like the investing version of The Secret (the “law of attraction”) than an accurate description of how the stock market works. In reality, there is no such thing as an objective intrinsic value, only different people’s opinions of intrinsic value. If you are planning to sell in a few years, you are still making a bet about other people’s future opinions.
Still, some argue that, if the price is very far from their estimate of intrinsic value, then it is safe to assume that it will revert at least somewhat toward the mean. Personally, I have seen no evidence that this is true. Stocks always seem able to get even further from my estimate of fair price. See Tesla or any meme stock for a recent example of this. Buying the stock amounts to a bet that other people will “come to their senses” within 1–3 years, and in most cases, nothing forces them to do so.
I see two sensible responses to this fact.
First, you could bite the bullet and accept that you are betting on what others will think in the future. In that case, there is no a priori reason to believe that a DCF spreadsheet is the most accurate way to predict it. You could apply any manner of prediction mechanism — machine learning, for example. You could look at new data sources. The most obvious data source, when trying to predict future transaction prices, is past transaction prices, but that means straying into the realm of technical analysis, which is anathema to fundamental analysts.
If your goal is to stay purely within fundamental analysis, then I think you are forced into the second option: never sell. If you hold until the eventual liquidation of company assets, collecting dividend payments along the way, then it doesn’t matter what anyone else is willing to pay for the stock. As far as I can tell, that is the one and only way that you avoid betting on other people’s opinions about the stock. In short, Buffett’s approach of having an ideal holding period of “forever” is the logical conclusion of a commitment to using fundamental analysis to pick stocks.
2. Outperforming Requires Looking (Far) Into the Future
If you never sell, then as is well known, probably 90% or more of the value you are buying comes from cash flows arriving more than five years in the future. Thus, the inevitable conclusion, I think, is that fundamental analysts must be willing to make predictions about company fundamentals more than five years in the future. Once again, logic requires us to do something that is anathema to some value investors.
Rather than looking forward, these value investors pride themselves on how far they look backward. For example, they prefer last year’s earnings to analyst estimates of next year’s earnings, despite how accurate the latter usually are: each quarter, most companies’ earnings come within a few percentage points of the estimates. Academic research has consistently found that P/E multiples using next year’s earnings better explain stock prices than those using last year’s earnings.
Some prefer to look even further backward, not using just last year’s earnings but instead an average of several prior year’s earnings (often calling these “normalized earnings”). The CAPE ratio is one metric that uses this approach for valuing the entire market. Its poor recent track record doesn’t seem to diminish enthusiasm for using it. While the CAPE ratio worked well in prior centuries, it is theoretically unsound. I have yet to find any valuation textbook that includes past earnings in calculations of intrinsic value. They all include only future earnings.
Value investors usually justify their reluctance to look forward with beliefs about the strongly mean-reverting nature of company fundamentals, especially growth. I wrote an article two years ago about how that very idea led me astray for many years as an investor and how more recent data demonstrates there is less mean reversion than claimed: the top quintile of growers continue to grow faster than average for over a decade!
Buffett, of course, was one of the first to identify this phenomenon. He explained how companies with “moats” can maintain superior fundamentals for an extremely long time and encouraged investor to focus on identifying and buying those companies, even though they are typically more expensive by standard metrics like P/E. (Also, it’s not hard to update these metrics to work better. I explained one way in another past article.)
Some value investors incorporate moats into their strategy, identifying them with historical data, but maintaining their hesitancy to look forward. In my opinion, outperformance requires looking forward even after you own the stock: you must make the hard decision to sell before the market prices-in deteriorating fundamentals.
Just as stocks with improving fundamentals will usually appear overpriced, because the market prices some of that in, stocks with deteriorating fundamentals will usually appear underpriced. If they deteriorate for years, the stock could be underpriced for years, possibly all the way to zero. (This tendency of the market to price in a few years of future fundamentals is probably why “no stock in an up-trend has ever gone bankrupt”, as Walter Deemer likes to say.)
For myself, I will admit that much of the allure of the strong mean-reversion hypothesis is that it makes investing easy, but beating the market isn’t supposed to be easy, and Buffett’s outperformance is no evidence to the contrary. His insane work ethic — the hours invested in reading, learning, and thinking — point firmly in favor of hard work being required, with much of that hard work being thinking about the future.
3. Accounting Matters
The value of a business comes not from its revenue but from the part of profits that could be paid out as a dividend. The calculation of “profit”, however, requires a careful matching of revenues with the expenses paid to produce those revenues, the result of careful accounting.
Some value investors have a deep distrust of accounting. They prefer instead to look only at cash flows. However, as I wrote about in the past, that does not solve the problem. Comparing cash inflows and outflows in a given year is only matching revenues with the corresponding expenses for companies that are not growing. This sort of “cash accounting” undervalues growing business and overvalues shrinking ones, making it a sure fire recipe for underperformance.
In recent years, parts of the value investing community have brought attention to this issue, particularly in response to the rise of the largest tech companies whose software development costs are routinely expensed in a different year than when they generate revenue. OSAM found that trying to restore matching (by “capitalizing intangibles”) would have generated superior returns.
As usual, Buffett, I think, has been onto this for decades. While other value investors prefer “free cash flow” as their calculation of potential dividend, Buffett’s metric is “owner’s earnings”. The two are conceptually similar, but the latter notably relies on accounting earnings, not cash flows.
I would also point out that, while Charlie Munger may take the occasional shot at non-GAAP metrics, Berkshire Hathaway itself likes to report non-GAAP metrics. They have noted the GAAP’s requirement that they mark their investment portfolio to market every quarter makes their accounting earnings essentially meaningless. (This is a perfect example of the accounting problems I discussed in the article mentioned above.) Instead, they report earnings without those changes, a non-GAAP metric.
For myself, I will admit that the allure of cash accounting is, once again, simply that it is easier. But as I said above, beating the market isn’t supposed to be easy. We should expect outperformance to require us to do the (hard) accounting work necessary to understand the true profitability of each business.
4. The Market Rewards Optimism
Owning a stock for the long term requires optimism about the future prospects of the business. Even owning an S&P 500 index fund requires faith in the long term prospects of the US economy. For over a hundred years, that optimism has been rewarded.
Investors, though, are not only interested in the part of the returns that come from the overall growth of the stock market, so-called “beta”, but also in the outperformance of the investment, its so-called “alpha”. An analogy that is silly but nonetheless useful for me is thinking of beta as coming from optimism and alpha as coming from contrarianism. To gain alpha, you need to buy stocks that the market is underpricing (or short stocks that the market is overpricing), which requires a contrary view to the market.
By this analogy, an outperforming investment, beta + alpha, comes from contrarian optimism. The most basic way to outperform is to buy the S&P 500 when market sentiment is extremely poor, when others think the good times will never return. You are rewarded not only with the beta of the growing US economy but also with the alpha of being right that things were not so bad as they seemed.
Value investing requires having a contrary view, but some value investors, I think, have a contrary view not because they are contrarian optimists but because they are pessimists. Perpetually convinced that a recession is just around the corner, they always have one foot out the door. The strategy of pessimists is not beta + alpha: it is –beta.
Pessimism is a recipe for continual underperformance because, despite all our focus on alpha, beta is a much larger component of returns than alpha. Even if the pessimists are occasionally right and collect some alpha, over the long term –beta + alpha < beta. That is, pessimists will underperform a basic strategy of simply betting on the US economy via an index fund.
It always shocks me that many pessimistic value investors are also fans of Warren Buffett because Buffett is a relentless optimist. If that wasn’t clear enough from his cheery demeanor, just a few years ago, he spelled it out in clear and simple terms: “Never bet against America.” No one could say it any more simply: –beta is a losing strategy.
Obviously, I’m not adding anything by saying that Buffett knows what he is doing, but the four points described above are probably the key insights that caused me to move away from Ben Graham’s toward something closer to Buffett’s approach for discretionary stock picking.
Final Thoughts
In our discussion above, it should not surprise us that we needed distinguish between quantitative and discretionary investing strategies. Those are two very different areas of investing. As I’ve written about before, it usually doesn’t even make sense to use the same metrics to measure performance for both types: quantitative strategies are probably best measured with relative performance, while discretionary strategies are probably best measured with absolute performance.
In the end, I come away with opinions of Graham’s approaches to quantitative and discretionary investing that point in opposite directions. While Graham’s approach to discretionary investing is, in my mind, overvalued and more investors should be taking Buffett’s lessons to heart, I continue to think that Graham’s approach to quantitative investing is undervalued, especially in terms of its influence and track record. While Buffett is undoubtedly the GOAT of discretionary stock picking, Graham is one who is in the discussion for GOAT of quantitative investing.
